Financial Holding Companies (Section 4(k) of the BHC … · writing and agency activities, merchant bank-ing, and insurance company portfolio investment activities. The GLB Act includes

Financial Holding Companies(Section 4(k) of the BHC Act) Section 3900.0

WHAT’S NEW IN THIS REVISEDSECTION

Effective January 2015, footnote 1 is revised toindicate that SR-12-17/CA-12-14 supersedesSR-99-15. See section 2124.05 of this manual.

The Gramm-Leach-Bliley Act (the GLB Act)became effective on March 11, 2000. The GLBAct authorized affiliations among banks, securi-ties firms, insurance firms, and other financialcompanies. To further this goal, the GLB Actamended section 4 of the BHC Act to allow abank holding company (BHC) or foreign bankthat qualifies as a financial holding company(FHC) to engage in a broad range of activitiesthat (1) the GLB Act defines as financial innature or incidental to a financial activity, or(2) the Board, in consultation with the Secretaryof the Treasury, determines to be financial innature or incidental to a financial activity. Fur-thermore, section 4 of the BHC Act authorizesan FHC to engage in designated financial activi-ties, including insurance and securities under-writing and agency activities, merchant bank-ing, and insurance company portfolio investmentactivities.

The GLB Act includes conditions that mustbe met for a BHC or a foreign bank to bedeemed a ‘‘financial holding company’’ andengage in expanded activities. The GLB Actalso allows an FHC to seek Board approval toengage in any activity that the Board determines(1) is complementary to a financial activity and(2) does not pose a substantial risk to the safetyand soundness of depository institutions or thefinancial system generally. BHCs that do notqualify as FHCs are limited to engaging in thosenonbanking activities that were permissible undersection 4(c)(8) of the BHC Act before enact-ment of the GLB Act.

The GLB Act provides that, in most cases, anFHC may engage in or acquire the shares of acompany that is engaged in financial activitieswithout obtaining prior approval from the Board.An FHC is instead required to provide a post-commencement notice to the Board within 30days after commencing a financial activity oracquiring a company. See section 4(k) of theBHC Act. Prior approval from the Board isrequired to acquire or engage in the activities ofa savings association.

3900.0.1 FHC SUPERVISORYOVERSIGHT AUTHORITY

Under the GLB Act, the Federal Reserve hassupervisory oversight authority and responsibil-ity for BHCs, including BHCs that operate asFHCs. The GLB Act sets forth parameters foroperating relationships between the FederalReserve and other regulators. The statute differ-entiates between the Federal Reserve’s relationswith (1) depository institution regulators and(2) functional regulators, which include insur-ance, securities, and commodities regulators.There should be minimal, if any, noticeablechange in the well-established relationshipsbetween the Federal Reserve as BHC (includingFHC) supervisor and the bank and thrift supervi-sors (federal and state). The Federal Reserve’srelationships with functional regulators will, inpractice, depend on the extent to which an FHCis engaged in functionally regulated activities;those relationships will also be influenced byexisting working arrangements.

The Federal Reserve’s supervisory oversightrole is that of an umbrella supervisor concentrat-ing on a consolidated or group-wide analysis ofan organization. Umbrella supervision is not anextension of more traditional bank-like supervi-sion throughout an FHC. The FHC frameworkis consistent with and incorporates principlesthat are well established for BHCs. The FHCsupervisory policy focuses on addressing super-visory practice for and relationships with FHCs,particularly those that are engaged in securitiesor insurance activities. See SR-00-13.

3900.0.2 ROLES OF SUPERVISORS

The Federal Reserve is responsible for the con-solidated supervision of FHCs. In this regard,the Federal Reserve will assess the holding com-pany on a consolidated or group-wide basis withthe objective of ensuring that the holding com-pany does not threaten the viability of its deposi-tory institution subsidiaries. The manner in whichthe Federal Reserve fulfills this role will likelyevolve along with the activities and structure ofFHCs, and it may differ depending on the mixof banking, securities, and insurance activitiesof an FHC.

Depository institution subsidiaries of FHCsare supervised by their appropriate primary bank

BHC Supervision Manual January 2015Page 1

or thrift supervisor (federal and state). The GLBAct did not alter the role of the Federal Reserve,as holding company supervisor, vis-a-vis theprimary supervisors of FHC-associated bankand thrift subsidiaries. Traditionally, the FederalReserve has relied to the fullest extent possibleon those supervisors.

Nonbank (or nonthrift) subsidiaries engagedin securities, commodities, or insurance activi-ties are supervised by their appropriate func-tional regulators. Such functionally regulatedsubsidiaries include a broker, dealer, investmentadviser, and investment company registered withand regulated by the Securities and ExchangeCommission (SEC) (or, in the case of an invest-ment adviser, registered with any state); aninsurance company or insurance agent subject tosupervision by a state insurance regulator; and anonbank subsidiary engaged in activities regu-lated by the Commodity Futures Trading Com-mission (CFTC).

3900.0.3 FHC SUPERVISIONOBJECTIVES

The Federal Reserve, as umbrella supervisor,will seek to determine that FHCs are operated ina safe and sound manner so that their financialcondition does not threaten the viability of affili-ated depository institutions. Oversight of FHCs(particularly those engaged in a broad range offinancial activities) at the consolidated level isimportant because the risks associated with thoseactivities can cut across legal entities and busi-ness lines. The purpose of FHC supervision is toidentify and evaluate, on a consolidated or group-wide basis, the significant risks that exist in adiversified holding company to assess how theserisks might affect the safety and soundness ofdepository institution subsidiaries.

Accordingly, the Federal Reserve will focuson the financial strength and stability of FHCs,their consolidated risk-management processes,and overall capital adequacy. The Federal Reservewill review and assess the internal policies,reports, and procedures and the effectiveness ofthe FHC consolidated risk-management pro-cess. The appropriate bank, thrift, or functionalregulator will continue to have primary respon-sibility for evaluating risks, hedging, and riskmanagement at the legal-entity level for theentity or entities that it supervises.

FHC supervision is not intended to imposebank-like supervision on FHCs, nor is it intended

to duplicate or replace supervision by the pri-mary bank, thrift, or functional regulators ofFHC subsidiaries. Rather, FHC supervision seeksto protect the depository institution subsidiariesof increasingly complex organizations with sig-nificant interrelated activities and risks, whilenot imposing an unduly duplicative or onerousburden on the subsidiaries of the organization.Effective financial holding company supervisionrequires—

1. strong, cooperative relationships between theFederal Reserve and primary bank, thrift,and functional regulators and foreign super-visors (these relationships respect the indi-vidual statutory authorities and responsibili-ties of the respective supervisors, but alsoallow for enhanced information flows andcoordination so that individual responsibili-ties can be carried out effectively withoutcreating duplication or excessive burden);

2. substantial reliance by the Federal Reserveon reports filed with or prepared by bank,thrift, and functional regulators, as well as onpublicly available information for both regu-lated and nonregulated subsidiaries; and

3. continued reliance on the risk-focused super-vision and examination process and on mar-ket discipline.

3900.0.4 FHC SUPERVISION INPRACTICE

The supervisory activities of the Federal Reservefall into three broad categories: (1) informationgathering, assessments, and supervisory coop-eration; (2) ongoing supervision; and (3) promo-tion of sound practices and improved disclosure.

3900.0.4.1 Information Gathering,Assessments, and SupervisoryCooperation

To fulfill its GLB Act responsibilities, the Fed-eral Reserve needs to interact closely andexchange information with the primary bank,thrift, and functional regulators. The FederalReserve will foster strong relationships withsenior management and the boards of directorsof FHCs, and have access to timely informa-tion from FHCs. These relationships will needto include heads of significant business linesand key internal-audit, control, and risk-management officials in order to understandhow risk-management and internal-control poli-cies and procedures established at the consoli-

Financial Holding Companies (Section 4(k) of the BHC Act) 3900.0


dated level are being implemented and assessed.To achieve these objectives, Federal Reservesupervisory staff will take the following actions:

1. Regularly assess an FHC’s centralized risk-management and control processes. Suchassessments are necessary to understand anorganization’s overall risk profile, identifymaterial contributions to core risks, and deter-mine how such risks are being managed andcontrolled on a consolidated basis.

2. Perform limited, targeted transaction testing.The purpose of this transaction testing is toverify that the risk-management systems ofthe FHC are adequately and appropriatelymeasuring and managing areas of risk for theorganization, and to confirm that laws andregulations applicable to the FHC and withinthe jurisdiction of the Federal Reserve arebeing observed.

3. Have periodic discussions with FHC seniormanagement and boards of directors. Suchdiscussions will enable the Federal Reserveto build relationships with key personnel andto understand changing activities and theevolving risk profile of the consolidatedorganization. Periodic discussions also willprovide a forum for supervisory staff to pres-ent any findings or concerns related to theactivities of the group as a whole or to busi-ness lines that cut across legal entities.

4. Have periodic discussions with key person-nel. Discussions will be held with the person-nel responsible for corporate managementand control functions, such as heads of busi-ness lines, risk management, internal audit,and internal control.

When performing the above tasks, FederalReserve supervisory staff, to the extent possible,will coordinate their actions with those of theprimary bank, thrift, and functional regulators ofthe FHC’s subsidiaries. For example, to under-stand the risks and risk-management systems ofan FHC at the consolidated level, the FederalReserve will need information concerning assetsor liabilities booked in significant bank, thrift,and functionally regulated subsidiaries withinthe FHC group. The primary bank, thrift, andfunctional regulators of such subsidiaries alsomay need information from the FHC to performtheir respective statutory mandates. To assist insharing needed information, Federal Reservesupervisory staff should do the following:

1. Have periodic meetings with the primarybank, thrift, and functional regulators of anFHC’s subsidiaries. The purpose of these

meetings is to develop an understanding ofthe risk profiles of the individual regulatedlegal entities and their relation to the FHC’soverall risk profile. These meetings also shouldbe used, when appropriate, to share informa-tion regarding supervisory plans and to coor-dinate supervisory activities and follow-up,as needed.

2. Review the examination findings of primarybank, thrift, and functional regulators (andtheir self-regulatory organizations) togetherwith other relevant information. The purposeof this review is to develop a consolidatedpicture of the FHC’s financial condition andrisk profile, the effectiveness of risk-management and internal-control policies,and the implications for the affiliated deposi-tory institutions.

3. Make available to primary bank, thrift, andfunctional regulators, to the extent permis-sible, pertinent information regarding theFHC. Included is information on the finan-cial condition, risk-management policies, andoperations of an FHC that may have a mate-rial impact on individual regulated subsidi-aries, as well as information concerning trans-actions or relationships between the regulatedsubsidiaries and other subsidiaries within theFHC group. This process will assist supervi-sors in performing their statutory and super-visory responsibilities over regulatedsubsidiaries.

4. Participate in the sharing of informationamong international supervisors, consistentwith applicable law. The purpose of thisexchange is to ensure that an FHC’s globalactivities are supervised on a consolidatedbasis and to minimize material gaps insupervision.

5. Review internal-audit and managementreports and publicly available information(including market information on equity anddebt prices of the consolidated organiza-tion), as well as reports and statistics col-lected by other regulators, including regula-tors of depository institution subsidiaries. Tolimit regulatory burden, this informationshould be obtained, to the fullest extent pos-sible, from (1) the parent organization; (2) pri-mary bank, thrift, and functional regulatorsof the FHC’s regulated subsidiaries; and(3) publicly available sources, such as exter-nally audited financial statements.



3900.0.4.2 Ongoing Supervision

3900.0.4.2.1 FHC Structure,Management, and the ApplicationsProcess

The Federal Reserve is responsible for under-standing the consolidated organization’s legal,organizational, and risk-management structure;major business activities; and risk exposuresand risk-management systems. The FederalReserve needs to understand the nature anddegree of involvement of the board of directorsin overseeing their organization’s risk-management and control process at the consoli-dated group level. The Federal Reserve, whenconsidering any formal application, declaration,or notification at the FHC level, will coordinate,as appropriate, with primary bank, thrift, andfunctional regulators.

3900.0.4.2.2 Reporting and Examination

The Federal Reserve will rely, to the fullestextent possible, on reports that an FHC or itssubsidiaries are required to file with federal orstate authorities (or self-regulatory organiza-tions) or on reports that are prepared by thefederal or state authorities. The Federal Reservewill rely on routinely prepared managementreports, publicly reported information, andexternally audited financial statements. The Fed-eral Reserve also will rely to the fullest extentpossible on the examination of an FHC’s bankand nonbank subsidiaries by their appropriateprimary bank, thrift, and functional regulators(and their self-regulatory organizations).

If supervisory staff requires a specializedreport from a functionally regulated subsidiaryof an FHC, staff will first request it from thesubsidiary’s appropriate functional regulator. Inthe event that the report is not made available tothe Federal Reserve, supervisory staff may obtainthe report directly from the functionally regu-lated subsidiary if it is necessary to assess—

1. a material risk to the FHC or any of itsdepository institution subsidiaries;

2. compliance with any federal law that theFederal Reserve has specific jurisdiction toenforce against the FHC or a subsidiary; or

3. the FHC’s systems for monitoring and con-trolling financial and operational risks thatmay pose a safety-and-soundness threat to adepository institution subsidiary.

The Federal Reserve may examine a function-ally regulated subsidiary under certain circum-stances. Before examining a functionally regu-lated subsidiary, supervisory staff should firstseek to obtain the necessary information fromthe appropriate functional regulator. If an exami-nation is determined to be necessary, the FederalReserve should coordinate its actions with theappropriate functional regulator. An examina-tion may be conducted when the Federal Reservehas reasonable cause to believe (or reasonablydetermines) that—

1. the subsidiary is engaged in an activity thatposes a material risk to an affiliated deposi-tory institution,

2. the examination is necessary to be adequatelyinformed about the FHC’s systems for moni-toring and controlling the financial andoperational risks that may pose a safety-and-soundness risk to a depository institutionsubsidiary; or

3. the subsidiary is not in compliance with anyfederal law that the Board has specific juris-diction to enforce (and the Board cannotdetermine compliance by examining the FHCor its affiliated depository institutions).

The Federal Reserve, consistent with its cur-rent practice, will continue relying to the fullestextent possible on the work performed by bank,thrift, and functional regulators to validate thatmaterial risks are measured and managedadequately at the regulated subsidiary level.Where necessary and appropriate, and consis-tent with (1) through (3) immediately above, theFederal Reserve may conduct or participate inreviews at banks, thrifts, or functionally regu-lated subsidiaries to validate that risk-management and internal-control policies estab-lished at the consolidated level are beingimplemented effectively.

For an FHC subsidiary that is not supervisedby a bank, thrift, or functional regulator, theFederal Reserve will obtain information fromthe subsidiary, as appropriate and necessary, toassess the financial condition of the FHC as awhole. In addition, the Federal Reserve willconduct examinations of such subsidiaries, ifnecessary, to be informed about (1) the nature ofthe subsidiary’s operations and financial condi-tion, (2) the subsidiary’s financial and opera-tional risks that may pose a threat to the safetyand soundness of any depository institution sub-sidiary of the FHC, and (3) the systems formonitoring and controlling such risks. Underthe GLB Act, the Federal Reserve may notexamine any subsidiary of an FHC that is an



investment company registered with the SECand that is not itself a BHC.

3900.0.4.2.3 Capital Adequacy

The Federal Reserve is responsible for assessingconsolidated capital adequacy for FHCs, withthe ultimate objective of protecting the insureddepository subsidiaries from the effects of dis-ruptions in the nonbank portions of the organi-zation. Capital adequacy will be assessed inrelation to the risk profile of the consolidatedorganization. The Federal Reserve will reviewthe FHC’s internal risk assessment and relatedcapital-analysis process for determining theadequacy of its overall capital position. Such areview will include consideration of current andfuture economic conditions, business-development plans for the future, possible stressscenarios, and internal risk-control and auditprocedures. As BHCs, FHCs are subject to theFederalReserve’sholdingcompanycapitalguide-lines, which set forth minimum capital ratiosthat serve as tripwires for additional supervisoryscrutiny and corrective action. The FederalReserve will review these requirements as theyapply to FHCs and may, if warranted, adapt themanner in which they apply to FHCs that engagein a broad range of financial activities.

Although the Federal Reserve is responsiblefor assessing the consolidated capital adequacyof FHCs, the primary bank, thrift, or functionalregulators of FHC subsidiaries will continue toset and enforce applicable capital requirementsfor the regulated entities within their jurisdic-tion. Under the GLB Act, the Federal Reservemay not establish separate capital adequacyrequirements for an FHC subsidiary that is incompliance with the capital requirements of itsfunctional regulator.

Consistent with current practice, the FederalReserve will continue to place significant reli-ance on the primary bank, thrift, or functionalregulator’s analysis of the capital adequacy of aregulated subsidiary. That analysis will be asignificant input in the Federal Reserve’s assess-ment of an FHC’s consolidated capital adequacy,especially when a securities broker-dealer orinsurance company is a predominant part of anFHC.

Several issues become particularly importantwhen assessing the consolidated capital adequacyof FHCs with functionally regulated subsidi-aries. The capital adequacy requirements thathave been established for banking, securities,and insurance entities by their respective regula-tors reflect varying definitions of the elements

of capital and varying approaches to asset andliability valuations. Yet techniques for assessingcapital adequacy must be able to identify situa-tions such as double or multiple leverage ordouble-gearing. In such cases, the actual capitalprotection may be overstated.

3900.0.4.2.4 Intra-Group Exposures andConcentrations

Intra-group exposures, including servicingarrangements and risk concentrations, have thepotential to threaten the condition of regulatedentities. Intra-group exposures may be signifi-cant at large, complex FHCs, especially thosethat operate their businesses on global lines thatcut across legal entities within the firm. TheFederal Reserve’s focus in this area is the poten-tial impact of intra-group exposures and concen-trations on insured depository institution subsid-iaries of an FHC.

Risk concentrations can take many forms,including exposures to one or more counterpar-ties or related entities, industry sectors, and geo-graphic regions. For risk concentrations, theholding company supervisor is uniquely posi-tioned to understand the combinations of expo-sures within an organization across all legalentities. This understanding is critical at thegroup level—risk concentrations that are pru-dent on a legal-entity basis may aggregate to anunsafe level for the consolidated organization.The Federal Reserve will monitor intra-groupexposures and risk concentrations as follows:

1. The appropriate primary bank and thrift regu-lators will continue to monitor and enforcesection 23A and 23B restrictions at the bankor thrift level. The Federal Reserve will focuson assessing whether the FHC monitors andensures compliance with these statutoryrequirements. The Federal Reserve plans tobegin collecting data from each depositoryinstitution subsidiary of BHCs, includingFHCs, on their covered transactions withaffiliates that are subject to sections 23A and23B and will share that data with primarybank and thrift regulators.

2. Functional regulators will continue to moni-tor and enforce any intra-group exposurerestrictions that may apply to the regulatedentities under their jurisdictions.

3. The Federal Reserve will focus on under-standing and monitoring related-party expo-



sures at the group level (including areas suchas servicing agreements, derivatives expo-sures, and payments-system exposures). Animportant emphasis will be the extent towhich risk management in a group’s subsidi-ary depository instutions depends on transac-tions with affiliates.

4. The Federal Reserve will focus on manage-ment’s effectiveness in monitoring and con-trolling intra-group exposures and risk con-centrations. The Federal Reserve will considerhow an organization’s risk-management pro-cesses measure and manage group-wide riskconcentrations.

3900.0.4.2.5 Enforcement Powers

The Federal Reserve is authorized generally totake enforcement action against FHCs and theirnonbank subsidiaries. The primary bank andthrift supervisors have the authority to takeenforcement action against the banks and thriftsunder their respective jurisdictions. Under theGLB Act, the Federal Reserve may takeenforcement action against a functionally regu-lated subsidiary of an FHC, but only when suchaction is necessary to prevent or redress anunsafe or unsound practice or breach of fidu-ciary duty that poses a material risk either to(1) the financial safety, soundness, or stability ofan affiliated depository institution or (2) thedomestic or international payments system. Insuch circumstances, the Federal Reserve mayonly take the action if it is not reasonably pos-sible to protect effectively against the materialrisk through an action directed at or against anaffiliated depository institution.

Under any circumstances, the Board may takeenforcement action against a functionally regu-lated subsidiary to enforce compliance with anyfederal law that the Federal Reserve has specificjurisdiction to enforce against the subsidiary. Ifthe Federal Reserve believes that an enforce-ment action against a functionally regulatedentity is necessary, the Federal Reserve willnotify the entity’s appropriate functional regula-tor and, whenever practical, will coordinate suchan action with any action taken by the func-tional regulator. It is expected that the FederalReserve will not take an enforcement actionagainst a functionally regulated subsidiary (or aperson associated with the subsidiary) if theproblem involves factors and statutes that are

the primary responsibility of the functional regu-lator.

Under the existing bank holding companyframework, the Federal Reserve coordinatesenforcement actions with the primary bank andthrift regulators, possibly with some adaptationof the action for the holding company context(such as limitations on parent company debt ordividends). The Federal Reserve will continueto coordinate enforcement actions with theseregulators. Similarly, the Federal Reserve willcoordinate with functional regulators when for-mulating and issuing enforcement actions thatinvolve or may have an impact on functionallyregulated subsidiaries.

3900.0.4.3 Promotion of Sound Practicesand Improved Disclosure

The Federal Reserve can promote sound prac-tices in a number of ways, such as by monitor-ing trends in risk exposures and risk-management practices across the FHC populationthrough a combination of efforts, including—

1. regular discussions, centered on specific issuesand emerging risks, with FHC management;

2. regular meetings with primary bank, thrift,and functional regulators to explore and dis-cuss issues of mutual interest or concern;

3. interagency working groups or specialty teamsto gain early insight into risks that cut acrossthe various entities of a conglomerate orgroups of conglomerates; and

4. industry conferences on relevant topics ofinterest.

These initiatives will contribute to the develop-ment of sound practices that the Federal Reserveand the primary bank, thrift, and functionalregulators can communicate to the senior man-agement and boards of directors of the FHCs, aswell as to the senior management of their bankand nonbank subsidiaries.

Improved transparency and public disclosurecan meaningfully supplement the efforts ofsupervisors to monitor the increasingly complexand global activities of diversified banking orga-nizations. Consistent with sound accounting prin-ciples, practices, and depository institution safety-and-soundness practices, the Federal Reservewill participate in efforts to enhance disclosuresthat will illuminate group-wide activities, riskexposures, risk management, controls, and intra-group exposures.



3900.0.4.4 Supervisory Response toChallenges Posed by FHCs

The Federal Reserve’s response to the supervi-sory challenges of FHCs has been in the contextof the consolidated supervision of BHCs.1

Examples include greater reliance on risk-focused supervision; strengthening relationshipswith senior management; improving coordina-tion with other federal, state, and internationalregulatory and supervisory authorities; greaterreliance on specialty teams, sound-practicespapers, and public disclosures; and simplifica-tion of the applications process.

The more diversified FHCs present newsupervisory challenges. To address these chal-lenges, the Federal Reserve will continue tostrengthen—

1. cooperative arrangements with bank and thriftregulators, the SEC, the CFTC, state insur-ance and securities regulators, and foreignsupervisors;

2. relationships with the FHC management andpersonnel responsible for significant risk-management functions and, when necessary,the management of the organization’s non-bank subsidiaries;

3. information flows that provide supervisorswith relevant, up-to-date information withoutimposing an unwarranted burden on financialorganizations;

4. techniques for evaluating capital adequacyfor FHCs engaged in an expanded range ofnonbank financial activities;

5. public disclosures and market discipline;6. techniques for assessing the overall risk pro-

file of FHCs and the implications for affili-ated depository institutions; and

7. incentives for FHCs to continually reviewand improve their risk-management pro-cesses, internal controls, and audit practices.

The Federal Reserve is committed to workingconstructively and cooperatively with all regula-tors involved in overseeing the activities ofFHCs and their bank and nonbank subsidiaries.

1. The Federal Reserve’s framework for supervising large

complex banking organizations (LCBOs) is described in

SR-12-17/CA-12-14, “Consolidated Supervision for Large

Financial Institutions.” See section 2124.05.



U.S. Bank Holding Companies Operating as Financial HoldingCompanies (Section 4(k) of the BHC Act) Section 3901.0

To become a financial holding company (FHC),a domestic bank holding company (BHC) mustfile a written declaration with the appropriateFederal Reserve Bank. This declaration shouldcontain the following information:

1. A statement that the BHC elects to be anFHC.

2. The name and head-office address of thecompany and each depository institution con-trolled by the company. For purposes of theelection process for both domestic BHCs andforeign banks, the term ‘‘depository institu-tion’’ here means any national bank, state-chartered bank, federal branch of a foreignbank, insured branch of a foreign bank, sav-ings association, savings bank, and industrialbank. It also includes any trust company thatengages in the business of receiving depositsother than trust funds. (See 12 U.S.C. 1813.)A depository institution does not have tohave FDIC insurance.

3. A certification that all depository institutionscontrolled by the company are well capital-ized as of the date the company files itsdeclaration.

4. The capital ratios for all relevant capital mea-sures (as defined in section 38 of the FederalDeposit Insurance Act), as of the close of theprevious quarter, for each depository institu-tion controlled by the company on the datethe company files its declaration.

5. A certification that all depository institutionscontrolled by the company are well managedas of the date the company files its declara-tion.

A depository institution is well managed if, atthe most recent inspection or examination orsubsequent review by its appropriate federalbanking agency, the institution received (1) atleast a satisfactory composite rating and (2) atleast a satisfactory rating for management, ifsuch a rating is given. In the case of a deposi-tory institution that has not received an inspec-tion or examination rating, a depository institu-tion is well managed if the Board has determined,after a review of the depository institution’smanagerial and other resources and after con-sulting with the depository institution’s appro-priate federal and state banking agency, that theinstitution is well managed. In addition, a deposi-tory institution that results from the merger oftwo or more depository institutions that are wellmanaged will be considered to be well managedunless the Board determines otherwise after

consulting with the appropriate federal bankingagency for each depository institution involvedin the merger.

A depository institution that results from themerger of a depository institution that is wellmanaged with one or more depository institu-tions that are not well managed or that have notbeen examined will be considered to be wellmanaged, if the Board determines that the result-ing institution is well managed. The Boardmakes this determination after a review of themanagerial and other resources of the resultinginstitution and after consulting with the appro-priate federal and state banking agencies for theinstitutions involved in the merger, asapplicable.

The Gramm-Leach-Bliley Act (the GLB Act)also requires that all the insured depository insti-tutions controlled by the FHC at the time of thedeclaration must be rated satisfactory or betterunder the Community Reinvestment Act (CRA).When determining whether the insured deposi-tory institutions controlled by a BHC meet theCRA requirement, the Federal Reserve excludesan institution that was acquired during the 12months preceding the date the company filed itsdeclaration. To qualify for this exception, (1) thecompany must have submitted the depositoryinstitution’s affirmative correction plan to theappropriate federal banking agency and (2) theagency must have accepted the plan.

A BHC must file its declaration to become anFHC with the appropriate responsible ReserveBank. A BHC’s election to become an FHC iseffective on the thirty-first day after the date thata complete declaration was received, unless theBoard notifies the company before that time thatthe election is ineffective. The Board or theappropriate Federal Reserve Bank also maynotify a BHC in writing that its election tobecome an FHC is effective before the thirty-first day after the date that a complete declara-tion was filed.

When an FHC’s declaration becomes effec-tive, it may engage in the expanded financialactivities available to such companies. If, how-ever, the Board has timely notified a BHC thatits declaration is ineffective, the BHC will notbe considered an FHC and may not begin toengage in any expanded activities.

A company that is not a BHC may simulta-neously submit an application under section3(a)(1) of the Bank Holding Company Act (BHC

BHC Supervision Manual July 2009Page 1

Act) to become a BHC and to request to becomean FHC on consummation of that transaction.The company must (1) state that it seeks tobecome an FHC on consummation of its section3 proposal to become a BHC and (2) certify thateach depository institution that would be con-trolled by the company on consummation of thesection 3 proposal will be both well capitalizedand well managed on the date of consummation.To coordinate action on these two requests, theacceptance of the declaration as complete doesnot occur until the date the company lawfullyconsummates its section 3 proposal and becomesa BHC. A simultaneous declaration will not beeffective if the Board notifies the company atany time before consummation that (1) anydepository institution that would be controlledby the company on consummation will not bewell capitalized and well managed or (2) anyinsured depository institution that would be con-trolled by the company on consummation hasnot achieved at least a satisfactory rating at itsmost recentCRAexamination.An insureddeposi-tory institution that is controlled or would becontrolled by a company filing a simultaneousdeclaration and section 3(a)(1) application tobecome a BHC may not be excluded for thepurposes of evaluating the CRA performancerecord under this provision or the general FHCcertification requirements of section 225.82(d)of Regulation Y.

In most cases, an FHC may, without provid-ing prior notice to or obtaining prior approvalfrom the Board, conduct an activity that is finan-cial in nature or incidental to a financial activity(a financial activity). (See section 225.85(a)(1)of Regulation Y.) An FHC may conduct a finan-cial activity by engaging directly in the activityor by acquiring and retaining the shares of anycompany that is engaged exclusively in one ormore financial activities. An FHC may conducta financial activity at any location inside oroutside of the United States, subject to the lawsof the jurisdiction in which the activity is con-ducted. A company acquired or to be acquiredby an FHC also may engage in other activitiesthat are permissible for an FHC, in accordancewith any applicable notice, approval, or otherrequirements.

An FHC may acquire more than 5 percent ofthe voting shares or control of a company that isnot engaged exclusively in activities that arefinancial in nature, incidental to financial activi-ties, or otherwise permissible for the acquiringFHC. (See section 225.85(a)(3) of Regulation

Y.) To do so, the acquisition must meet threerequirements:

1. The company to be acquired must be sub-stantially engaged in activities that are finan-cial in nature, incidental to a financial activ-ity, or otherwise permissible for the FHCunder section 4(c) of the BHC Act. A com-pany is considered to be substantially engagedin permissible activities if at least 85 percentof the company’s consolidated total annualgross revenues is derived from and at least85 percent of the company’s consolidatedtotal assets is attributable to the conduct ofactivities that are financial in nature, inciden-tal to a financial activity, or otherwise per-missible for an FHC under section 4(c) of theBHC Act. An FHC’s management shouldconsult with Board staff if they are uncertainwhether a proposed acquisition meets thisstandard.

2. The FHC must comply with the noticerequirements of section 225.87 of RegulationY. The acquired company must conform, ter-minate, or divest, within two years of thedate the FHC acquires shares or control ofthe company, all activities that are not finan-cial in nature, incidental to a financial activ-ity, or otherwise permissible for the FHCunder section 4(c) of the BHC Act. Althoughan FHC may acquire any percentage of sharesor control of a company engaged in limitedimpermissible activities, the FHC needs onlyto provide a post-transaction notice if suchanacquisition results incontrolof thecompany.

3. After being acquired by an FHC, the com-pany engaged in impermissible activities maynot engage in or acquire a company engagedin any activity that is not permissible for theFHC.

Section 225.85(c) of Regulation Y identifiestwo circumstances in which Board approval isstill required to engage in financial activities.First, prior approval in accordance with section4(j) of the BHC Act and section 225.24 ofRegulation Y is required to acquire more than5 percent of the voting shares or control of asavings association or any company that owns,operates, or controls a savings association. Sec-ond, the Board may, in the exercise of its super-visory authority, require an FHC to provide itwith prior notice or obtain prior Board approvalif circumstances warrant. The GLB Act did notchange in any way the requirement that a com-pany receive prior Board approval under section3 of the BHC Act before acquiring shares orcontrol of a bank.

U.S. Bank Holding Companies Operating as Financial Holding Companies 3901.0


Section 225.87(a) of Regulation Y requiresan FHC that commences an activity, or thatacquires control or shares of a company engagedin an activity under section 225.86 of Regula-tion Y, to provide written notice to the appropri-ate Reserve Bank within 30 calendar days aftercommencing the activities or consummating theacquisition. The notice must be provided on theFR Y-10 form, obtained from the Board or anyReserve Bank. This requirement also applies toan activity that the FHC may engage in undersection 4(c)(8) of the BHC Act that is incorpo-rated under section 4(k) of the act.

There are two circumstances in which noticeto the Board is not required to engage in anactivity: (1) when an FHC acquires shares of acompany without acquiring control of the com-pany, or (2) when an FHC is engaged in securi-ties underwriting, dealing, or market-makingactivities described in section 4(k)(4)(E), mer-chant banking investment activities conductedpursuant to section 4(k)(4)(H), or insurancecompany investment activities conducted pursu-ant to section 4(k)(4)(I) of the BHC Act, andhas provided the System with the appropriatenotice regarding the relevant activity. (See sec-tion 225.87(b) of Regulation Y.) Under thesecircumstances, the FHC must provide writtennotice to the Board within 30 days after acquir-ing, as part of a merchant banking activity undersection 4(k)(4)(H) or an insurance companyinvestment activity under section 4(k)(4)(I) ofthe BHC Act, more than 5 percent of any com-pany at a cost that exceeds 5 percent of theFHC’s tier 1 capital or $200 million, whicheveris less.

3901.0.1 SUPERVISORY CONCERNS

In some instances, a U.S. BHC or a foreign bankmay meet the statutory requirements to be anFHC, but its capital strength and managerialresources are less than satisfactory on a consoli-dated basis. In this situation, the Federal Reservemay have supervisory concerns about the con-solidated entity although it technically qualifiesas an FHC. The Federal Reserve may, in theexercise of its supervisory authority, restrict orlimit the conduct of new activities or futureacquisitions of an FHC, or take other appropri-ate action, if it finds that the FHC does not havethe financial or managerial resources to conductthe activity or make the acquisition. This super-visory action could be based, for example, on adetermination that the company does not haveadequate capital or risk-management systems toconduct a specific activity in a safe and sound

manner and may involve the issuance of cease-and-desist orders, the execution of written agree-ments, or other appropriate supervisory action.

3901.0.2 HOLDING COMPANY FAILSTO CONTINUE MEETING FHCCAPITAL AND MANAGEMENTREQUIREMENTS

If a domestic bank holding company has madean effective election to be an FHC, and theBoard finds that any depository institution sub-sidiary owned or controlled by the companyceases to be well capitalized or well managed,the company must execute an agreement accept-able to the Federal Reserve Board to complywith all applicable capital and managementrequirements. This agreement should be executedwithin 45 days after the Board notifies the com-pany that it is not in compliance with the appli-cable requirements for an FHC. (See section225.83 of Regulation Y.)

At the request of the bank holding company,the Federal Reserve Board may extend the 45-day period. The request should state why anextension is necessary. The agreement mustexplain the specific actions that the bank hold-ing company will take to correct all areas ofnoncompliance, provide a schedule for all suchactions, and provide any other information theBoard may require, and be acceptable to theBoard.

During the period of noncompliance, the Fed-eral Reserve Board may impose limitations orconditions on the activities of the company. Inaddition, the company must obtain the Board’sapproval before conducting any of the activitiesthat are newly authorized for FHCs by the GLBAct. Section 225.83 of Regulation Y also setsforth the consequences of failing to correct thenoncompliance within a period of 180 days.Such consequences may include divestiture ofownership or control of any depository institu-tion the company owns or controls, or the cessa-tion of the expanded activities permitted forFHCs.

3901.0.3 DEPOSITORY INSTITUTIONSUBSIDIARY FAILS TO MAINTAIN ASATISFACTORY OR BETTER CRARATING

The Federal Reserve Board prohibits an FHC


BHC Supervision Manual December 2001Page 3

from engaging in any additional activity1 oracquiring control of a company engaged in anyactivity under section 4(k) and 4(n) of the BHCAct if any insured depository institution con-

trolled by the FHC fails to maintain a satisfac-tory or better CRA rating.

3901.0.4 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws 1 Regulations 2 Interpretations 3 Orders

BHCs and foreign banks that qualifyas FHCs can engage in financialactivities and those incidental thereto

1843

Definition of an FHC 225.81 4-056

Election to become an FHC 225.82 4-056.1

Failure to meet applicable capital andmanagement requirements

225.83 4-056.2

Consequences of the failure to main-tain at least a satisfactory CRA rating

225.84 4-056.3

Notices or approvals for FHCs toengage in financial activities

225.85 4-056.4

Activities permissible for FHCs 228.86 4-056.5

Post-commencement notice for FHCto engage in a financial activity

225.87 4-056.6

Board determination that an FHCactivity is financial in nature or inci-dental thereto

225.88 4-056.7

Board approval for an FHC to engagein an activity that is complementary toa financial activity

225.89 4-056.8

1. 12 U.S.C., unless specifically stated otherwise.2. 12 C.F.R., unless specifically stated otherwise.

3. Federal Reserve Regulatory Service reference.

1. With respect to engaging in any additional activities, seesection 225.84 of Regulation Y for the exceptions.



Foreign Banks Operating as Financial HoldingCompanies (Section 4(k) of the BHC Act) Section 3903.0

3903.0.1 FINANCIAL HOLDINGCOMPANY QUALIFICATIONREQUIREMENTS FOR FOREIGNBANKS

A foreign bank that owns or controls a U.S.bank (and any company that controls the foreignbank) must comply with the same requirementsas a domestic bank holding company (BHC)that elects to be treated as a financial holdingcompany (FHC). Either entity is thus able toengage in authorized financial activities underthe Gramm-Leach-Bliley Act (GLB Act). If aforeign bank does not own a subsidiary bank inthe United States, but instead operates through abranch, agency, or commercial lending com-pany located in the United States, the foreignbank (and any company that controls the foreignbank) is subject to the Bank Holding CompanyAct (BHC Act) as if the foreign bank or com-pany were a BHC. Such foreign banks may, likeU.S. BHCs, also elect to be treated as FHCs.Foreign banks electing to be treated as FHCsmust meet ‘‘well-capitalized’’ and ‘‘well-managed’’ standards comparable to those thatare applicable to U.S. depository institutions.Futher, any U.S. branches of the foreign bankthat are FDIC-insured must be rated satisfactoryor better under the Community ReinvestmentAct (CRA).1 (See section 225.90 of RegulationY.)

To be treated as an FHC, a foreign bank (or acompany that owns or controls a foreign bank)that operates in the United States only throughU.S. branches, agencies, or commercial lendingsubsidiaries must file a written declaration withthe appropriate Reserve Bank. This declarationmust contain items 1 through 6 below. Foreignbanks or companies that operate in the UnitedStates through U.S. branches, agencies, or com-mercial lending companies and through a U.S.subsidiary bank are not required to provide item1, but they must provide the items domesticBHCs are to provide.

1. a statement that the foreign bank or companyelects to be treated as an FHC

2. the risk-based capital ratios and the amountsof tier 1 capital and total assets of the foreignbank as of the close of the most recent quar-

ter, and as of the close of the most recentaudited reporting period

3. a certification that the foreign bank meets thestandards to be well capitalized that are setout in section 225.90(b)(1)(i) and (ii) or sec-tion 225.90(b)(2) of Regulation Y, as of thedate the foreign bank or company files itselection

4. a certification that the foreign bank is wellmanaged, as defined in section 225.90(c)(1)of Regulation Y, as of the date the foreignbank or company files its election

5. a certification that all U.S. depository institu-tions controlled by the foreign bank or com-pany (including thrifts and nonbank trustcompanies) are well capitalized and wellmanaged as of the date the foreign bank orcompany files its election

6. the capital ratios and all relevant capital mea-sures (as defined in section 38 of the FederalDeposit Insurance Act) for all U.S. deposi-tory institution subsidiaries of the foreignbank or company as of the end of the previ-ous quarter

The well-capitalized and well-managed tests initems 2, 3, and 4 above apply to each foreignbank that has U.S. operations in the form of abranch, agency, or commercial lending com-pany subsidiary that is part of a foreign bankingorganization seeking certification as an FHC.

For those foreign banks whose home-countrysupervisors have adopted risk-based capital stan-dards consistent with the Basel Accord, theirtier 1 and total risk-based capital ratios, as calcu-lated under the home-country standard, must beat least 6 percent and 10 percent, respectively.The Board will determine the comparability ofthe foreign bank’s capital under the listed com-parability factors in section 225.92(e) of Regula-tion Y. Among these factors are the compositionof the foreign bank’s capital, accounting stan-dards, long-term debt ratings, the ratio of tier 1capital to total assets, reliance on governmentsupport to meet capital requirements, the for-eign bank’s anti–money laundering procedures,whether the foreign bank is subject to compre-hensive consolidated supervision, and other fac-tors that may affect the analysis of capital andmanagement.2 For those foreign banks whose

1. Under the GLB Act, the capital and management stan-dards the Board must apply to foreign banking organizationsthat elect to become FHCs should be comparable to thestandards applied to domestic institutions, giving due regardto the principle of national treatment and equality of competi-tive opportunity.

2. The Board may consider whether the overall level of theforeign bank’s capital and other factors indicate that addi-


home-country supervisors have not adopted theBasel Accord and for any other foreign bankingorganizations that otherwise do not meet thecapital standards noted above, the foreign bankmay be considered well capitalized by obtainingfrom the Board a prior determination that itscapital is otherwise comparable to the capitalthat would be required of a U.S. banking organi-zation to become an FHC. The pre-clearanceprocess provided by section 225.91(c) of Regu-lation Y can be used to obtain this determina-tion.

A foreign bank will be considered well man-aged if—

1. the branches, agencies, and commercial lend-ing subsidiaries of the foreign bank havereceived at least a satisfactory composite rat-ing at their most recent examination;3

2. the home-country supervisor of the foreignbank consents to the foreign bank expandingits activities in the United States to includeFHC activities;4 and

3. the Board determines that the managementof the foreign bank meets standards compa-rable to those required of a U.S. bank ownedby an FHC.

The Board believes that, as a general rule, thetop tier foreign bank in a foreign banking groupthat requests an FHC determination should besubject to comprehensive consolidated supervi-sion by the home-country supervisor.

As a general matter, a foreign bank will notbe determined to be well capitalized and wellmanaged when it is not subject to comprehen-sive consolidated supervision. When a foreignbank has not been determined by the Board tobe subject to comprehensive consolidated super-vision, and the Board has not deemed any otherbank from the country where the foreign bank ischartered to be subject to comprehensive con-solidated supervision, the foreign bank must usethe pre-clearance process provided by section225.91(c) of Regulation Y—even if it otherwisemeets the objective screening criteria. The Boardmay review a foreign bank’s home-countrysupervision through the pre-clearance processand make a comprehensive consolidated super-vision determination in that context. The Boardwill try to make a determination on pre-clearance requests within 30 days of receipt.5

There may be limited situations when anexceptionally strong bank from a country thathas not yet fully implemented comprehensiveconsolidated supervision should be consideredfor FHC status. Such a foreign bank can qualifyfor FHC status if (1) the home-country supervi-sor has made significant progress in adoptingand implementing arrangements for the consoli-dated supervision of its banks, and (2) the for-eign bank demonstrates significant financialstrength, such as through high levels of capitalor exceptional asset quality. The Board antici-pates, however, that a foreign bank that is notsubject to comprehensive consolidated supervi-sion will be granted FHC status only in rareinstances.

As in the case of domestic BHCs, each U.S.depository institution subsidiary of a foreignbank is required to meet all the well-capitalizedand well-managed standards in order for theforeign bank or company to obtain FHC statusin the same manner as required for U.S. BHCs.In addition, all the U.S. insured depository insti-tutions controlled by the foreign bank or com-pany must be rated satisfactory or better underthe CRA. If the foreign bank operates a U.S.branch that is FDIC-insured, the branch must berated satisfactory or better under the CRA.

tional analysis should be undertaken to assess comparability.The Board will not impose a specific standard for the foreignbank’s ratio of tier 1 capital to total assets (the leverage ratio),but a foreign bank’s leverage ratio may be among the factorstaken into account in the comparability review.

3. The Federal Reserve’s foreign bank examination pro-cess includes the assignment of a combined assessment (thecombined ROCA rating) of a foreign banking organization’s(FBO’s) U.S. branch, agency, and commercial lending opera-tions through the regular examination cycle. (See SR-00-14.)The combined ROCA rating will be factored into the FBO’soverall combined U.S. operations rating, which will continueto be a single composite rating that reflects the U.S. supervi-sors’ collective assessment of all operations (that is, bankingand nonbanking) of the FBO in the United States. If a foreignbank wishes to obtain FHC status, but does not have theassignment of a combined U.S. banking assessment as part ofthe regular examination cycle, the foreign bank can contact itsresponsible Federal Reserve Bank or engage in the pre-clearance process. If a foreign banking group contains morethan one foreign bank with U.S. banking offices, each suchforeign bank in the group must have a satisfactory compositeU.S. banking assessment in order for the foreign bankinggroup or any of its subsidiaries to obtain FHC status.

4. The home-country supervisor should consider the FBO’sconsolidated capital and management before providing itsconsent to the expansion. If the home country has no formalconsent process, the Board will consult with the supervisor toassure itself that the supervisor considers the capital andmanagement of the bank to satisfy its home-country standardsand that the supervisor has no objections to the expansion.

5. If the Board makes an affirmative comprehensive con-solidated supervision determination through the FHC pre-clearance process, the determination will be relied on for theforeign bank to establish additional branches and agenciesunder the Foreign Bank Supervision Enhancement Act.

Foreign Banks Operating as Financial Holding Companies 3903.0


An election by a foreign bank or company tobe treated as an FHC will become effective onthe thirty-first day after the date that an electionwas received by the appropriate Reserve Bank,unless the Board notifies the foreign bank orcompany before that time that the election isineffective or unless the period for the Board’sdetermination is extended with the consent ofthe foreign bank or company making the elec-tion. The date the Federal Reserve Bank receivesthe declaration should be considered the firstday of the 30-day review period. The Board orthe Reserve Bank also may notify a foreignbank or company in writing that its election tobecome an FHC is effective before the thirty-first day after the election was filed. A foreignbank or company should file the declaration (orpre-clearance request) with the responsibleReserve Bank.

If the election is determined to be effective,the foreign bank or company may engage in thefinancial activities available to FHCs. The GLBAct requires that an FHC that engages in anactivity, or that acquires control or shares of acompany engaged in an activity, under section4(k) of the BHC Act provide written notice tothe appropriate Reserve Bank within 30 calen-dar days after commencing the activities oracquisition.Thenotice shoulddescribe theactivitycommenced or identify the name of the com-pany acquired and describe its activities.

3903.0.2 FOREIGN BANK FAILS TOCONTINUE MEETING FHC CAPITALAND MANAGEMENTREQUIREMENTS

If a foreign bank or company has made aneffective election, and the Board finds that theforeign bank; any foreign bank that is controlledby the foreign bank and maintains a U.S. branch,agency, or commercial lending company; or anyU.S. depository institution owned or controlledby the foreign bank or company ceases to bewell capitalized or well managed, the foreignbank or company must execute an agreementacceptable to the Federal Reserve Board to com-

ply with all applicable capital and managementrequirements. This agreement should be executedwithin 45 days after the Board notifies the for-eign bank or company that it is not in compli-ance with the applicable requirements for anFHC. (See section 225.93 of Regulation Y.) Atthe request of the foreign bank or company, theBoard may extend the 45-day period. (The requestshould state why an extension is necessary.) Theagreement must explain the specific actions thatthe foreign bank or company will take to correctall areas of noncompliance, provide a schedulefor all such actions, provide any other informa-tion the Board may require, and be acceptable tothe Board. During the period of non-compliance, the Board also may impose limita-tions or conditions on the U.S. activities of theforeign bank or company. Section 225.93 ofRegulation Y also sets forth the consequencesof failing to correct the noncompliance within aperiod of 180 days. Such consequences mayinclude termination of the foreign bank’s U.S.branches and agencies and divestiture of itscommercial lending company subsidiaries, orcessation of the expanded activities permittedfor FHCs. The foreign bank may also choose tocease engaging in activities not permitted for aforeign bank under sections 2(h) and 4(c) of theBHC Act.

3903.0.3 INSURED BRANCH FAILSTO MAINTAIN A SATISFACTORY ORBETTER CRA RATING

When an insured branch of a foreign bank, or aninsured depository institution controlled by aforeign bank, fails to maintain a satisfactory orbetter CRA rating, section 225.94 of RegulationY applies the provisions of section 225.84 to theforeign bank and to any company that owns orcontrols the foreign bank. For these purposes,the insured branch is treated as an ‘‘insureddepository institution.’’ An FHC is thus prohib-ited by the Board from engaging in any addi-tional activity or acquiring control of a companyengaged in activities under section 4(k) or 4(n)of the BHC Act.( See section 225.84 of Regula-tion Y.)





BHCs and foreign banks that qualifyas FHCs can engage in financialactivities and those incidental thereto

1841(h)1843(c)

Election of a foreign bank to becomean FHC

225.91 4-057.2

How elections by foreign banks to bean FHC become effective

225.92 4-057.3

Foreign bank fails to satisfy capitaland management requirements

225.93 4-057.4

Foreign branch fails to retain a satis-factory CRA rating

225.94225.84

4-057.74-056.5





Permissible Activities for FHCs(Section 4(k) of the BHC Act) Section 3905.0


Effective July 2008, this section was revised to

include the Board’s September 7, 2007, determi-

nation, by order, at the FDIC’s request, that

disease management and mail-order pharmacy

activities complement the financial activity of

underwriting and selling health insurance; per-

missible for an FHC under section 4 (k) of the

BHC Act, as amended by the Gramm-Leach-

Bliley (GLB) Act (see 2007 FRB C133). (An

applicant had filed an application with the FDIC

for deposit insurance for a proposed de novo

industrial loan company.) The Board determined

the activities to be financial in nature under

section 4(k) of the BHC Act and complementary

to a financial activity. The Board’s determina-

tion is conditioned and based on the limitations

it placed on the activities in the aggregate (that

is, the specified percentages of the applicants’

consolidated total assets, consolidated total

annual revenues, and total capital).

The section is also amended for the Board’s

approvals of FHC notices, under section 4 of

the BHC Act, to provide energy management

services under energy management agreements

and also, energy tolling. On December 4, 2007,

the Board determined, by order, that an FHC’s

provision of energy management services is

complementary to the financial activities of

engaging as principal in physical commodity

derivatives and the providing of financial and

investment advisory services for derivative trans-

actions. (See 2008 FRB C20.) On March 27,

2008, the Board also determined, by order, that

an FHC’s providing energy tolling is comple-

mentary to the financial activity of engaging in

commodity derivatives activities (see 2008 FRB

60).

The section has been revised to also delete a

reference to an interim Board rule that is final.

See 225.4(g) of Regulation Y (12 C.F.R. 225.4(g)).

This rule pertains to nonbank activities involv-

ing the underwriting and dealing in, or making

a market in, bank-ineligible securities under

section 4(k)(4)(E) of the BHC Act.

3905.0.1 NONBANK ACTIVITYAUTHORIZATIONS FOR FHCS

The Gramm-Leach-Bliley Act (the GLB Act)amended the Bank Holding Company Act (theBHC Act) to allow a BHC or foreign bank thatqualifies as a financial holding company (FHC)

to engage in a broad range of activities that theGLB Act defines as ‘‘financial in nature.’’ Sec-tion 4(k)(4)(A)–(E) of the BHC Act defines thefollowing activities as financial in nature:

1. lending, exchanging, transferring, investingfor others, or safeguarding money orsecurities

2. insuring, guaranteeing, or indemnifyingagainst loss, harm, damage, illness, disabil-ity, or death, or providing and issuing annu-ities, and acting as principal, agent, or brokerfor purposes of the foregoing, in any state

3. providing financial, investment, or economicadvisory services, including advising aninvestment company (as defined in section 3of the Investment Company Act of 1940)

4. issuing or selling instruments representinginterests in pools of assets permissible for abank to hold directly

5. underwriting, dealing in, or making a marketin securities

The Board had previously determined that someof these activities were impermissible for BHCs,such as acting as principal, agent, or broker forpurposes of insuring, guaranteeing, or indemni-fying against loss, harm, damage, illness, dis-ability, or death, and issuing annuity products.Permissible insurance activities as principalinclude reinsuring insurance products.

An FHC acting under section 4(k)(4)(B) ofthe BHC Act may conduct insurance activitieswithout regard to the restrictions on the insur-ance activities imposed on BHCs under section4(c)(8).

Providing claims-administration and risk-

management services. Legal counsel represent-ing an FHC sought an opinion as to whether aninsurance agency owned by an FHC may engagein certain insurance claims activities, as describedbelow, under section 4(k)(4)(B) of the BHCAct. In particular, it was asked whether such aninsurance agency may engage in the followingclaims-administration activities in connectionwith its insurance sales activities: (1) collectinginsurance premiums; (2) holding insurance pre-miums in trust; (3) establishing an insuranceclaims–paying account; (4) adjusting insuranceclaims (which would include obtaining factsabout claims, investigating the veracity of claims,and estimating losses relating to claims);


(5) negotiating with insureds and their represen-tatives concerning insurance claims; and (6) pay-ing and settling insurance claims. A representa-tion was made that insurance agents typicallyperform these claims-administration services foran insurance underwriter in connection withinsurance policies sold by the agents on behalfof an insurance underwriter.

With respect to the insurance risk-management activities provided in connectionwith insurance sales activities, a legal opinionwas requested as to whether an insurance agencyor broker owned by an FHC could engage in thefollowing activities: (1) assessing the risks of aclient seeking insurance and identifying the cli-ent’s exposures to loss; (2) designing programs,policies, and systems (such as workplace safetyprograms) to reduce the client’s risks; (3) advis-ing clients about risk-management alternativesto insurance (such as self-insurance, securitiza-tion, or derivatives); and (4) negotiating insur-ance coverages, deductibles, and premiums foran insurance client. It was represented thatinsurance agents and brokers provide these risk-management services to their customers in con-nection with the sale of insurance products,including, in particular, commercial propertyand casualty insurance, and other insuranceactivities. It also was understood that the pro-posed risk-management services would (1) berelated to managing insurable risks, (2) be advi-sory in nature, and (3) not allow the risk man-ager to control or perform operations of itsclients.

Board staff noted that most states require aperson performing one or more of the insuranceclaims–administration services listed above tobe licensed by, or registered with, the appropri-ate insurance authority of the state as an insur-ance company, an insurance agent, or a third-partyadministrator (TPA).1 The legislativehistoryof the GLB Act also suggests that the Congress

believed that insurance-related claims-administration services are a necessary part ofthe insurance sales and underwriting activitiesauthorized by section 4(k)(4)(B).2

State insurance laws generally do not requirecompanies that provide insurance risk-management services to obtain a special insur-ance license. However, states generally do requirea license of any person who negotiates insur-ance coverages, deductibles, and premiums foranother.3

In a legal opinion dated July 10, 2002, Boardstaff opined that the specific insurance claims–administration services listed above are encom-passed within the insurance activities authorizedby section 4(k)(4)(B) of the BHC Act and thatthe services may be conducted by an FHC whenthey are provided by an insurance agent orbroker in connection with its other insurancesales activities. In addition, Board staff believesthat the specific insurance risk-management ser-vices listed above are encompassed within sec-tion 4(k)(4)(B) insurance activities and that theservices may be conducted by an FHC if they(1) are provided by an insurance agent or brokerin connection with its other insurance salesactivities, (2) involve managing insurable risks,(3) are advisory in nature, and (4) do not allowthe FHC to control, or perform operations of,the person to whom the services are provided.4

Acting as a third-party administrator. Otherlegal counsel representing a BHC that had electedto become an FHC requested an opinion onwhether acting as a TPA on behalf of an insur-ance company is an activity that is permissiblefor an FHC under the BHC Act. The BHCproposed to invest in a company that acts as aTPA for licensed insurance companies thatunderwrite and sell credit life insurance. A TPAprovides one or more insurance companies withadministrative and related services that supportand assist the sale of insurance products by the

1. For example, the Model Third Party Administrator Stat-ute adopted by the National Association of Insurance Com-missioners (NAIC) requires a person who collects premiumsor adjusts or settles claims for an insurer in connection withthe sale of life or health insurance policies or annuities toregister with the relevant state insurance authority as a TPA ifthe person is not already registered with the state as aninsurance company, agent, or broker. See the NAIC ModelThird Party Administrator Statute, sections 1.A and 11 (1996).

The NAIC’s Model Managing General Agents Act alsorequires a person to register with the relevant state insuranceauthority if the person adjusts or pays claims for an insurerand engages in certain other activities on behalf of an insurer.See NAIC Model Managing General Agents Act, sections 2.Cand 3 (1993).

2. See H.R. Rep. No. 106-74, part I, p. 122 (1999) (‘‘Activitiessuch as administering, marketing, advising or assisting with . .. claim administration or similar programs shall be deemed tobe incidental to insurance activities as described in [section4(k)(4)(B)].’’).

3. See NAIC Producer Licensing Model Act, sections 2.Kand 3 (2000).

4. A BHC or an FHC may provide advice to customersconcerning financial matters, including insurance, self-insurance, securitizations, and derivatives, under 12 C.F.R.225.28(b)(6), and may provide management consulting adviceto customers regarding nonfinancial equity matters, such asworkplace safety, subject to Regulation Y’s limits and restric-tions. See 12 C.F.R. 225.28(b)(9) (management consultingactivities permissible for all bank holding companies) and225.86(b)(1) (management consulting activities permissiblefor all FHCs).

Permissible Activities for FHCs 3905.0


insurance company. A TPA may provide someor all of the following services to an insurancecompany: (1) assisting the insurance companyin designing its insurance programs (which wouldinclude policy and certificate development andissuance); (2) determining whether a prospec-tive insured meets the insurance company’sestablished underwriting guidelines; (3) collect-ing and processing insurance premiums; (4) pro-cessing, adjudicating, and paying claims onbehalf of the insurance company; (5) investingexcess cash and maintaining bank accounts forthe insurance company; (6) establishing riskreserves for the insurance company; (7) advis-ing on, and arranging for, reinsurance or stop-loss insurance for the insurance company; (8) pre-paring and filing tax returns and regulatoryreports for the insurance company and provid-ing other related services designed to ensurethat the insurance company remains properlylicensed and in compliance with applicable gov-ernment regulations; (9) providing accountingand recordkeeping services to the insurancecompany in connection with its insurance activi-ties; and (10) providing insurance-product salestraining to employees of the insurance company.It was represented that the BHC may engage insome, but not all, of the activities in its capacityas a TPA.

The Board’s staff noted that the activitieslisted above are directly related to the provisionand sale of insurance by a third-party insurancecompany and constitute an integral part of theregulated insurance activities of the third-partyinsurance company. Consequently, most statesrequire a person performing one or more ofthese services for an insurance company to belicensed by, or registered with, the appropriateinsurance authority of the state either as aninsurance company or agent or as a TPA. Inaddition to the previously stated requirements,the Model Third Party Administrator Statute(Model TPA Statute) requires a person to regis-ter as a TPA if the person accepts insurancecontracts for an insurer that meet the insurer’sunderwriting guidelines, assists an insurer in theoverall planning and coordination of its insur-ance program, or collects premiums or adjustsclaims for an insurer.5

In a legal opinion dated July 10, 2002, theBoard staff opined that the above-listed servicesare encompassed within the insurance activitiesauthorized by section 4(k)(4)(B) of the BHCAct when provided to, or on behalf of, an insur-ance company in connection with the sale orunderwriting of insurance. Staff concluded thatan FHC could, under section 4(k)(4)(B) of theBHC Act, provide these services to a third-partyinsurance company.

Section 4(k)(4)(F) of the BHC Act also definesas ‘‘financial in nature’’ any activity that theBoard determined to be closely related to bank-ing under section 4(c)(8) of the BHC Act by aregulation or order that was in effect on Novem-ber 12, 1999. Section 225.86(a)(1) of Regula-tion Y cross-references the long-standing ‘‘laun-dry list’’ of nonbanking activities (at section225.28(b)) permissible by regulation for BHCs.Section 225.86(a)(2) lists nonbanking activitiesapproved for BHCs by Board order as of Novem-ber 12, 1999.6 All activities an FHC may engagein pursuant to section 225.86(a) must be con-ducted subject to the terms and conditions inRegulation Y and the Board orders authorizingthose activities.

Section 4(k)(4)(G) of the BHC Act also defines‘‘financial in nature’’ as any activity (1) in whicha BHC may engage outside the United Statesand (2) that the Board has determined, by regu-lation or interpretations issued under section(4)(c)(13) of the BHC Act that were in effect onNovember 11, 1999, to be usual in conductingbanking or other financial services abroad.7 Sec-tion 225.86(b) lists three activities that the Boardhas found to be usual in connection with thetransaction of banking or other financial opera-tions abroad. These activities are—

1. providing management consulting services,including services to any person with respectto nonfinancial matters, as long as the ser-vices are advisory and do not allow the FHCto control the person to whom the servicesare provided (these services go beyond the

5. See the NAIC Model TPA Statute, sections 1.A and 11(1996). A person generally does not have to register as a TPAif the person is currently registered with the state as an insureror as an insurance agent or broker. See Model TPA Statute,section 1.A.(3) and (4).

Similarly, the NAIC’s Model Managing General AgentsAct requires a person to register with the relevant state insur-ance authority if the person manages all or part of the businessof an insurer or, subject to certain conditions, accepts or

rejects policies for the insurer and either adjusts or paysclaims for the insurer or negotiates reinsurance for the insurer.See the NAIC Model Managing General Agents Act, sections2.C and 3 (1993).

6. Section 20 company activities are not included in thislist. Section 4(k)(4)(E) of the BHC Act authorizes FHCs toengage in securities underwriting, dealing, and market-makingactivities in a broader form than was previously authorized byBoard order.

7. See sections 211.8 and 211.10 of Regulation K (12C.F.R. 211.8 and 211.10).



management consulting services that areallowed under section 225.28(b)(9) of Regu-lation Y and are incorporated by reference atsection 225.86(a)(1));

2. operating a travel agency in connection withfinancial services offered by the FHC or oth-ers; and

3. organizing, sponsoring, and managing amutual fund, as long as the fund does notexercise managerial control over the compa-nies in which it invests and the FHC reducesits ownership, if any, of the fund to less than25 percent of the equity of the fund withinone year (or such longer time as the Boardpermits) after sponsoring the fund.

The activities that a BHC is authorized toengage in outside the United States under sec-tions 211.8 and 211.10 of Regulation K havebeen either (1) authorized for FHCs in abroader form by the GLB Act (for example,underwriting, distributing, and dealing in secu-rities and underwriting various types of insur-ance) or (2) authorized in the same or a broaderform in Regulation Y (for example, data pro-cessing activities; real and personal propertyleasing; and acting as agent, broker, or adviserin leasing property).8 The remaining activitiesauthorized by section 4(k)(4) of the BHC Actare defined to be ‘‘financial in nature’’ undersection 4(k)(4)(H) and (I). These are merchantbanking activities conducted under section4(k)(4)(H) through a securities affiliate or anaffiliate thereof, or through an affiliate of an in-surance company (as defined in section4(k)(4)(I)(ii)) when the affiliate is registeredunder the Investment Advisers Act of 1940 andprovides investment advice to an insurancecompany or is an affiliate of such a registeredcompany. Under section 4(k)(4)(I), these mer-chant banking activities may be conducted byan insurance company. These activities must beconducted in accordance with the restrictionsand limitations under subpart J of RegulationY, sections 225.170 through 225.177.

Section 4(k)(1)(A) of the BHC Act also allowsFHCs to engage in activities that the Board, incoordination with the Secretary of the Treasury,determines to be financial in nature or incidentalto such financial activity (section 4(k)(2)(A)).

Section 225.86(d) of Regulation Y lists only oneactivity, acting as a finder, that has been autho-rized under this provision. (See section 3910.0of this manual.)

The Board, in consultation with the Secretaryof the Treasury, authorizes an FHC to engage inactivities by Board order that are determinedand approved to be financial in nature orincidental to a financial activity (section228.86(e)). Only one activity has been approvedby Board order under 225.86(e) in consulta-tion with the Secretary of the Treasury: theacquisition, management, and operation in theUnited Kingdom of certain defined-benefit pen-sion plans that are established by nonaffiliatedthird parties. This order was approved by theBoard on October 12, 2007. (See section 3912.0of this manual.)

Section 4(k)(1)(B) of the BHC Act allowsFHCs to seek Board approval to engage in anyactivity that the Board determines to be comple-mentary to a financial activity and does not posea substantial risk to the safety and soundness ofdepository institutions or the financial systemgenerally. Also with regard to section 4(k)(1)(B)of the BHC Act that an activity is complemen-tary to a financial activity, the Board determinedon September 7, 2007, by order, at the FDIC’srequest, that disease management and mail-order pharmacy activities complement the finan-cial activity of underwriting and selling healthinsurance. (See 2007 FRB C133). An applicanthad filed an application with the FDIC fordeposit insurance for a proposed de novo indus-trial loan company. The Board determined thedisease management and mail-order pharmacyactivities to be financial in nature under section4(k) of the BHC Act and activities that arecomplementary to a financial activity. The Boardconditioned its determination based on the limi-tations it placed on the activities in the aggre-gate (that is, the specified percentages of theapplicants’ consolidated total assets, consoli-dated total annual revenues, and total capital).

Also with regard to other activities that aredeemed to be complementary to a financialactivity, the Board approved, on December 4,2007, an FHC’s request to provide energy man-agement services to owners of power generationfacilities under energy management agreements.This is an activity that is complementary to thefinancial activities of engaging as principal incommodity derivatives and providing financialand investment advisory services for derivativestransactions. (See 2008 FRB C20.) In addition,the Board, on March 27, 2008, determined thatproviding energy tolling services is complemen-tary to the financial activity of engaging in

8. The Board also has approved, under section 4(c)(13) ofthe BHC Act, activities in individual orders. Section 4(k)(4)(G)of the BHC Act does not authorize an FHC to engage inactivities that the Board has authorized a BHC to provide inindividual orders.



commodity derivatives activities. (See 2008 FRBC60).

Previously, the Board had approved physicalcommodity trading in commodities that wereCFTC-approved for trading on a U.S. futuresexchange (unless specifically excluded by theBoard) or that were specifically approved by theBoard. With the Board’s approval of its March27, 2008, order (2008 FRB C60), the Boardspecifically approved physical commodity trad-ing in commodities not CFTC-approved fortrading on a U.S. futures exchange. The Boardrecognized that a market-maker may not seekCFTC approval for a particular commodity ifthere is already an established foreign tradingmarket, which may deter a U.S. exchange fromlisting a product. A derivatives contract that isbased on a commodity that trades on a non-U.S. exchange may be subject to a regulatorystructure comparable to the one administered bythe CFTC (trading on a non-U.S. exchange thatmay be sufficient to demonstrate that a marketfor the commodity in financially settledcontracts exists, that the commodity is fungible,and that it has a reasonably liquid market).Within this order, the Board approved theFHC’s request to take and make physicaldelivery of nickel, a metal that is traded on theLondon Metal Exchange. Within the sameBoard order, the Board recognized that manycommodities for which derivatives contractshave not been approved for trading by theCFTC or that are not traded on a non-U.S.exchange but that trade on established alterna-tive trading platforms may also be commodi-ties that have viable markets with financiallysettled contracts on the commodities and thatsatisfy fungibility and liquidity concerns.Standards were established to receive Boardapproval to engage in physical commodity trad-ing in non-CFTC-approved commodities tradedon alternative trading platforms in the U.S. or oncertain non-U.S. exchanges. The standards areconsistent with the Board’s existing limitedphysical commodity trading authority. (See sec-tion 3920.0 for more information on Boardorders approving limited physical-commodity-trading activities that are complementary to afinancial activity.)

Other permissible activities under section4(k)(4)(E) of the BHC Act are underwriting anddealing in or making a market in securitieswithout any limitation on revenues that can bederived from bank-ineligible securities. Theseactivities must be conducted in accordance withapplicable restrictions and limitations found inthe BHC Act and any regulations or supervisoryguidance adopted by the Board. The Board

adopted a rule pertaining to these activities.9 Itimposed two restrictions on FHCs engaged insecurities underwriting, dealing, or market-making activities. All intraday extensions ofcredit by a bank, thrift, or U.S. branch or agencyof a foreign bank to an affiliated companyengaged in these activities under section4(k)(4)(E) must be on market terms consistentwith section 23B of the Federal Reserve Act(FRA). In addition, a foreign bank that is anFHC must ensure that its U.S. branch or agencymaking a loan to, or purchasing securities as aprincipal or fiduciary from, such an affiliatedcompany complies with sections 23A and 23Bof the FRA as if the branch or agency were amember bank.

Section 4(k)(5) of the BHC Act requires theBoard and the Secretary of the Treasury todefine three categories of activities as financialin nature, as well as the extent to which theseactivities are financial in nature or incidental toa financial activity. These three categoriesencompass a wide range of activities:

1. lending, exchanging, transferring, investingfor others, or safeguarding financial assetsother than money or securities

2. providing any device or other instrumentalityfor transferring money or other financial assets

3. arranging, effecting, or facilitating financialtransactions for the account of third parties

The above categories include activities in whichFHCs and national banks and their financialsubsidiaries are already permitted to engage.For example, the categories include safe depositservices, electronic funds transfer activities, creditand stored-value card activities, securities bro-kerage, and finder activities. The categories areintended to allow FHCs and financial subsidi-aries to engage in activities that were not other-wise permitted for these companies. The proce-dure below allows an FHC or financial subsidiaryto obtain a determination from the Board andthe Secretary of the Treasury that an activity isfinancial in nature or incidental to a financialactivity pursuant to section 4(k)(5).

An FHC’s request for the Board to determinewhether an activity falls within one of the threecategories listed above must be in writing. Therequest must—

1. identify and define the activity for which the

9. See section 225.4(g) of Regulation Y.



determination is sought, specifically describ-ing what the activity would be and how theactivity would be conducted, and

2. provide information that supports the requesteddetermination, including information on howthe proposed activity falls into one of thethree categories, as well as any other infor-mation the Board requires concerning theproposed activity.

In making its determination, the Board willtake into account the same factors that it mustconsider when determining whether an activityis financial in nature or incidental to a financialactivity. These factors include, among other

things, changes in the marketplaces in whichFHCs and banks compete, changes in technol-ogy for delivering financial services, and whetherthe activity is necessary or appropriate to allowFHCs and their affiliates, or banks and theirsubsidiaries, to compete effectively with anycompany seeking to provide financial servicesin the United States.

If an activity is listed in more than one provi-sion of section 4 of the BHC Act, the FHC maychoose to conduct the activity under any appli-cable provision. The FHC is subject only to theprocedures and limitations that the chosen sourceof authority imposes on the activity.

3905.0.2 ACTIVITIES THAT ARE PERMISSIBLE FOR FHCs UNDER SECTION225.86(a) OF REGULATION Y

Activities That Are Financial in Nature or That Are Incidental to a Financial Activity

Manual

Section

3600.

1. Nonbanking activities listed in section 225.28(b) of Regulation Y that have beendetermined to be so closely related to banking as to be a proper incident thereto(see section 3000.0.2).

2. Any nonbanking activity that the Board has determined by order (those in effecton November 12, 1999) to be so closely related to banking as to be a proper inci-dent thereto. The activities are—

a. providing administrative and other services to mutual funds; 27

b. owning shares of a securities exchange; 6

c. acting as a certification authority for digital signatures, and authenticating theidentity of persons conducting financial and nonfinancial transactions (includestransactions abroad);

7

d. providing employment histories to third parties for use in making credit deci-sions and to depository institutions and their affiliates for use in the ordinarycourse of business;

29

e. check-cashing and wire-transmission services; 1

f. in connection with offering banking services, providing notary public services,selling postage stamps and postage-paid envelopes, providing vehicle-registration services, and selling public-transportation tickets and tokens; and

25

g. real estate title abstracting. 30

1. See 1990 FRB 860 and 1995 FRB 1130.

An FHC or other interested party may requestthat the Board, in consultation with the Secre-tary of the Treasury, determine that an addi-tional activity is financial in nature or incidentalto a financial activity. The written request should(1) identify and define the activity, specificallydescribing what the activity would involve and

how the activity would be conducted; (2) explainin detail why the activity should be consideredfinancial in nature or incidental to a financialactivity; and (3) provide information supportingthe request and any other information the Boardrequests concerning the proposed activity. (Seesection 225.88(b) of Regulation Y.)



An FHC may request an advisory opinionfrom the Board on whether a proposed specificactivity falls within the scope of an activityalready determined to be a financial activity andlisted in section 225.86 of Regulation Y. Therequest must be in writing and provide (1) adetailed description of the activity, product, orservice about which the company proposes toengage in or provide; (2) an explanation sup-porting an interpretation on the scope of thepermissible financial activity; and (3) any otherinformation the Board requests. (See section225.88(e) of Regulation Y.)

An FHC may request approval to engage inan activity that is complementary to a financialactivity. The written request must (1) identifythe proposed complementary activity, specifi-cally describing what the activity would involveand how it would be conducted; (2) identify thefinancial activity for which the proposed activitywould be complementary and provide informa-tion to support a finding that the proposed activ-ity should be considered complementary to theidentified financial activity; (3) describe thescope and relative size of the proposed activity,as a percentage of projected FHC revenues andon the basis of assets associated with conduct-ing the activity; (4) discuss the risks that con-ducting the proposed activity pose to the subsid-iary depository institutions of the FHC and thefinancial system in general; (5) describe thepotential adverse effects of conducting the activ-ity and explain the proposed measures the FHCwould take to address these potential effects;and (6) provide any other information the Boardrequests. (See section 225.89(a) of RegulationY.)

3905.0.3 SECURITIESUNDERWRITING, DEALING, ANDMARKET-MAKING ACTIVITIES

The GLB Act also authorizes securities under-writing, dealing, and market making without

regard to whether such securities may be soldby a bank. This activity includes underwritingor distributing shares of open-end investmentcompanies commonly referred to as mutual funds.

Securities underwriting activities conductedunder section 4(k)(4)(E) of the BHC Act may beconducted without regard to the 25 percent rev-enue limitation that is applicable to section 20nonbank subsidiaries of BHCs engaged in secu-rities underwriting and dealing, as authorized byBoard order under section 4(c)(8). In addition,dealing may be done without regard to the 5 per-cent limitation on ownership of voting securities.

The operating standards applicable to section20 companies do not apply to FHCs that engagein securities underwriting, dealing, and marketmaking under section 4(k)(4)(E) of the BHCAct, with two exceptions. First, intraday exten-sions of credit to a securities firm from anaffiliated bank or thrift or U.S. branch or agencyof a foreign bank must be on market termsconsistent with section 23B of the FRA. Sec-ond, foreign banks that are FHCs or that aretreated as FHCs are required to comply with therestrictions of sections 23A and 23B of the FRAwith respect to lending and securities-purchasetransactions between the U.S. branch or agencyof a foreign bank and a U.S. securities affiliate.The operating standards and revenue limit con-tinue to apply to BHCs that are not FHCs and toFHCs that continue to conduct securities activi-ties pursuant to section 4(c)(8) of the BHC Act.





BHCs and foreign banks thatqualify as FHCs can engage infinancial activities and thoseincidental thereto

1843

Activities permissible for anFHC

225.86 4-056.5

Notice requirement for FHCsengaging in a financial activity

225.87 4-056.6

Requests for Board to determinewhether an activity is financialin nature or incidental to a finan-cial activity

225.88 4-056.7

Request to engage in an activitythat is complementary to thefinancial activity of engaging asprincipal in BHC-permissiblecommodity derivatives

225.89 4-056.8 2003 FRB 5082004 FRB 2152004 FRB 511

Physical commodity trading inenergy-related commodities(natural gas, crude oil, electric-ity, and emissions allowances) asa complement to a financialactivity

1843(k)(1)(B) 2006 FRB C542006 FRB C572006 FRB C113

Disease management and mail-order pharmacy activities arecomplementary to the financialactivity of underwriting and sell-ing health insurance

1843(k)(1)(B) 2007 FRB C133

Providing energy managementservices is complementary to thefinancial activities of engagingas principal in commodityderivatives and providingderivatives investment advisoryservices

1843(k)(1)(B) 2008 FRB C20






Providing energy tolling servicesas a complement to the financialactivity of engaging in commod-ity derivatives activities

1843(k)(1)(B) 2008 FRB C60

Trading in commodities notapproved by the CFTC for trad-ing on a U.S. futures exchange(e.g., nickel on London MetalExchange) or on certain non-U.S. exchanges

2008 FRB C60





Disease Management and Mail-Order Pharmacy Activities(Section 4(k) of the BHC Act) Section 3906.0

In 2007, the Federal Deposit Insurance Corpora-tion (FDIC) requested the Board to determinewhether the disease management and mail-orderpharmacy activities are permissible for a finan-cial holding company (FHC) under the BankHolding Company Act (BHC Act), as amendedby the Gramm-Leach-Bliley Act (GLB Act).WP had filed an application with the FDIC toobtain deposit insurance for AFB, a proposedU.S.-based de novo industrial loan company(ILC).1

Section 4(k) (see 12 U.S.C. 1843(k)(4)) of theBHC Act permits a bank holding company(BHC) that qualifies to be an FHC to engage ina broad range of activities that are defined bystatute to be financial in nature. The FDICrequested that the Board determine the permissi-bility of WP’s disease management and mail-order pharmacy activities under the BHC Act,as amended by the GLB Act, in connection withthe FDIC’s moratorium then in place on actionson ILC applications by companies engaged inany nonbanking activity not permissible for anFHC.

WP is principally engaged in underwritingand selling health insurance and related activi-ties. Underwriting and selling health insuranceas principal, agent, or broker are activities deemedby Congress in the GLB Act to be financial innature.2 WP, through its regulated insurancecompany subsidiaries, provides health insur-ance. WP’s insurance offerings include pre-ferred provider, health maintenance, point ofservice, Medicare and Medicaid health plans;vision, dental, pharmacy benefit, life, disability,and long-term care insurance products; andconsumer-directed, high-deductible, and limited-service health insurance products. WP alsoengages in a variety of related activities, includ-ing claims processing.

WP also provides disease management andmail-order pharmacy services through subsidi-aries to persons who obtain health insurancefrom WP or another insurance company. Throughits disease management services, WP providesinsurance plan members with access to a varietyof tools and resources designed to help themmaintain healthy lifestyles and properly manage

their medical conditions. These disease manage-ment services typically are provided by, or underthe direction of, licensed health-care profession-als (including doctors and nurses) employed byWP. WP’s subsidiaries engage in providing mail-order pharmacy services, fill prescriptions forcustomers who have pharmacy benefit insurancecoverage from WP or another insurance com-pany, provide drug-related information to cus-tomers, and track potential issues with customerprescriptions, such as drug interactions. WP’smail-order pharmacy subsidiaries are state-licensed and employ state-licensed pharmacists.

WP’s disease management and mail-orderpharmacy activities are not within the scope ofactivities that the Board previously determinedto be financial in nature, incidental to a financialactivity, or complementary to a financial activityunder the provisions of the BHC Act. Theactivities do not themselves involve providinginsurance, are not regulated as insurance bystate insurance authorities, and are not providedby an affiliate that is licensed as an insurancecompany or as an insurance agent or broker.Both activities involve the provision of health-care services that, while related to insuranceunderwriting activities, are themselves nonfi-nancial activities. The Board concluded, how-ever, for the reasons set forth below, that there isa reasonable basis for construing these activitiesas complementary to a financial activity withinthe meaning of the GLB Act.

WP’s disease management and mail-orderpharmacy services help employers that obtainhealth insurance from an insurance company tomanage and reduce the risks and costs of provid-ing health insurance to employees. In its submis-sions to the Board, WP provided data demon-strating that many of the largest health insurersin the U.S. provide these services to their owncustomers and those of other health insurancecompanies and that employer-customers of heathinsurance companies often demand such services.

Based on the foregoing, the information pro-vided by WP, and other facts of record, theBoard concluded that disease management andmail-order pharmacy activities complement thefinancial activity of underwriting and sellinghealth insurance. Section 4(k)(1)(B) of the BHCAct requires that the Board determine that anyproposed complementary activity does not posea substantial risk to the safety or soundness ofdepository institutions or the financial system

1. Under section 4(c)(2)(H) of the BHC Act, an exemptionis provided from the definition of ‘‘bank’’ for ILCs. A BHCmay own, control, or operate an ILC, provided that it is not abank. Under section 225.28(b)(4) of the Board’s RegulationY, a BHC may acquire or retain an industrial bank to theextent authorized by state law.

2. See section 4(k)(4)(B) of the BHC Act (12 U.S.C.1843(k)(4)(B)).


generally.3 Moreover, the Board previously hasstated that complementary activities should belimited in size and scope relative to the financialactivities that they complement.4 As a conditionof its determination that the proposed activitiesare complementary to a financial activity, theBoard required that these activities in the aggre-gate not account for more than 2 percent ofWP’s consolidated total assets or 5 percent of itsconsolidated total annual revenues. In addition,the total assets of WP’s subsidiaries engaged indisease management or mail-order pharmacyactivities in the aggregate could not exceed5 percent of the total capital (calculated inaccordance with applicable statutory accountingprinciples) of all regulated insurance companysubsidiaries and health plans of WP. The Board

also considered how WP managed and addressedthe risks posed by the activities through insur-ance training and other measures. The Boardalso stated that any future extensions of creditby AFB to, or other covered transactions byAFB with, these or other affiliates, includingany covered transaction with an unaffiliated per-son the proceeds of which are transferred to orused for the benefit of an affiliate, must complywith sections 23A and 23B of the Federal ReserveAct and the Board’s Regulation W.5 For thesereasons, the Board concluded that the proposedactivities would not pose a substantial risk to thesafety and soundness of depository institutionsor the financial system generally. The Boardapproved the order on September 7, 2007 (Theprevious discussion is only a summary. See thefull text of the Board order at 2007 FRB C133).

3. See section 4(k)(1)(B) of the BHC Act (12 U.S.C.1843(k)(1)(B))

4. See 68 Federal Register 68493, 68497 (December 9,2003).

5. See the Federal Reserve Act, sections 371c and 371c-1(12 U.S.C. 371c, 371c-1) and 12 C.F.R. Part 223.

Disease Management and Mail-Order Pharmacy Activities 3906.0


Merchant Banking(Section 4(k) of the BHC Act) Section 3907.0

3907.0.1 MERCHANT BANKINGINVESTMENT AUTHORITY

The Gramm-Leach-Bliley Act (GLB Act) andthe Board’s Regulation Y permit financial hold-ing companies (FHCs) (but not bank holdingcompanies (BHCs) generally) to make invest-ments as part of a bona fide securities underwrit-ing or merchant or investment banking activity.1

These investments may be made in any type ofownership interest in any type of nonfinancialentity (portfolio company), and they may includeany amount up to all of the ownership interestsin the company. The investments that may bemade are substantially broader in scope than theinvestment activities that are otherwise permis-sible for BHCs.

The authority section 4(k)(4)(H) of the BankHolding Company Act (BHC Act) grants toFHCs to make merchant banking investments(MBIs) is an alternative to any other authoritythat the FHC may have to make investments innonfinancial companies under other provisionsof the BHC Act, except as specifically noted inthe rule. For example, the rule’s provisions donot apply to investments acquired as part ofsecurities underwriting, dealing, or market-making activities conducted under section4(k)(4)(E) of the BHC Act; investments madeby insurance underwriting subsidiaries of anFHC in accordance with section 4(k)(4)(I) ofthe BHC Act; investments made under section4(c)(6) or (7) of the BHC Act; or investmentsmade overseas under the Board’s Regulation K(12 C.F.R. 211).2 As described below, the BHCAct allows an FHC to make MBIs if it controls asecurities affiliate or controls both an insuranceunderwriter and a registered investment adviser.The GLB Act does contain certain limitationson MBIs made by FHCs, and it provides aframework for MBIs that is designed to helpmaintain the separation between banking andcommerce to ensure the safety and soundness ofdepository institutions. All MBIs made by an

FHC under section 4(k)(4)(H) must comply withthe Board’s rule.

3907.0.2 PERMITTED INVESTMENTS

Under section 4(k)(4)(H) of the BHC Act andthe Board’s rule, an FHC may acquire or controlany amount of shares, assets, or a full range ofownership interests in a company or other entitythat is engaged in an activity that isnot financialin nature, incidental to a financial activity, orotherwise permissible for the FHC under section4 of the BHC Act. The interests an FHC mayacquire include securities, warrants, partnershipinterests, trust certificates, other instruments rep-resenting an ownership interest in a company,and instruments convertible into a security orother ownership interest whether the interest isvoting or nonvoting. An FHC can acquireanyamount of ownership interests in the companyor other entity, whether or not that amountresults in control for purposes of the BHC Act.An FHC must file a notice with the Board undersection 4(k)(6) of the BHC Act and section225.87 of Regulation Y (12 C.F.R. 225.87)within 30 days after commencing MBI activitiesor acquiring any company that makes MBIs.3

An FHC also can acquire and control ‘‘assets’’other than debt or equity securities or otherownership interests of a company. For example,assets acquired as an MBI may include realestate or the assets of a division of an operatingcompany. To be permissible, the assets must beacquired through or promptly transferred to aportfolio company that has and maintains aseparate corporate existence, management, andoperations to the extent required by the rule.(See section 225.170(e)(3) of Regulation Y.)

3907.0.2.1 Securities Affiliate

A BHC may make MBIs only if it becomes anFHC.4 The FHC must either (1) control or be a‘‘securities affiliate’’ or (2) control both aninsurance underwriter affiliate and an invest-1. Unless stated otherwise in this section, the ‘‘merchant

banking statutory provisions’’ refer to section 4(k)(4)(H) ofthe Bank Holding Company Act, and references to the ‘‘rule’’or ‘‘regulatory provisions’’ pertain to Regulation Y and arefound in sections 225.170 through 225.177.

2. Although the rule does not apply to investments heldunder section 4(c)(6) or (7) of the BHC Act or the Board’sRegulation K, those authorities are only available if the FHC’saggregate investment in the relevant company under a combi-nation of authorities, including any investment made underthe merchant banking authority, is within the applicableinvestment limitations and restrictions set forth in section4(c)(6) or (7) or Regulation K.

3. See section 4(k)(6)(A) of the BHC Act (12 U.S.C.1843(k)(6)(A)) and section 225.87(a) of Regulation Y (12C.F.R. 225.87(a)).

4. The Board’s Regulation Y sets forth the procedures andqualification criteria applicable to BHCs that seek to elect tobecome an FHC. See section 225.81 et seq. of Regulation Y(12 C.F.R. 225.81 et seq.).

BHC Supervision Manual June 2001Page 1

ment adviser affiliate registered under the Invest-ment Advisers Act of 1940 that provides invest-ment advice to an insurance company. The GLBAct and the rule, however, do not require thatthe FHC make its MBIs through such a securi-ties, insuranceunderwriting,or investmentadviseraffiliate. Instead, an FHC may make MBIsdirectly or through any affiliate other than adepository institution or a subsidiary of a deposi-tory institution.

The rule defines a ‘‘ securities affiliate’’ toinclude any broker or dealer registered with theSecurities and Exchange Commission (SEC)under the Securities Exchange Act of 1934(Exchange Act). The definition also includes anSEC-registered municipal securities dealer,including a separately identifiable division ordepartment of a bank that is registered as amunicipal securities dealer under the ExchangeAct. An FHC may make MBIs if the holdingcompany is itself a registered securities brokeror dealer.

3907.0.2.2 Investments in CompaniesEngaged in Nonfinancial Activities

An FHC is authorized under section 4(k)(4)(H)of the BHC Act to acquire or control a companyor entity ‘‘ engaged in any activity not autho-rized pursuant to [section 4 of the BHC Act].’’An FHC may not make MBIs in financial com-panies under section 4(k)(4)(H) or the rule.FHCs have separate authority under other provi-sions of the BHC Act to make investments incompanies engaged in financial activities. How-ever, a company held as an MBI may be engagedin both nonfinancial and financial activities, andan FHC may retain an MBI in a nonfinancialcompany even if the company subsequentlycommences a financial activity. An FHC also isnot prohibited from using a combination ofauthorities to invest, through the same subsidi-ary or fund, in ownership interests of both non-financial and financial companies.

Investments in financial companies are notauthorized in section 4(k)(4)(H) of the BHCAct. The rule’s restrictions, such as those forholding periods and cross-marketing, thereforedo not apply to FHC investments in financialcompanies that are made under other provisionsof the BHC Act and the Board’s RegulationY—even if such investments are made for stra-tegic reasons or for reselling the investment. AnFHC may not, however, use the merchant bank-

ing authority to evade restrictions, such as con-sent or approval requirements or restrictions thataddress conflicts of interest or that govern theacquisition of financial companies.5 In addition,nothing in section 4(k)(4)(H) or the rule over-rides the prior-approval requirements of section3 of the BHC Act, which governs the acquisi-tion of shares of a bank or BHC, or the provi-sions of section 4(k)(6) and (j) of the BHC Act,which governs the acquisition of shares of asavings association or a company that controls asavings association.

3907.0.2.3 Bona Fide Underwriting orMerchant Banking or Investment Activity

An FHC may only make MBIs as part of a bonafide underwriting or merchant banking or invest-ment banking activity.6 An FHC is not autho-rized to make an investment in a nonfinancialcompany for the purpose of engaging in theactivities of the nonfinancial company, such asreal estate investment or development or otheractivities that have not been found to be finan-cial in nature. This ‘‘ bona fide’’ requirementthus preserves the financial nature of MBIactivities and the separation of banking fromcommerce.

The bona fide requirement does not prohibitan FHC from specializing in making MBIs inparticular industries or from making its firstMBI in a company engaged in real estate invest-ment or development. However, such invest-ments should be made only for investment aspart of an ongoing underwriting or investmentor merchant banking activity, and they shouldbe held in accordance with the Board’s rules.7

3907.0.2.3.1 Investments Made Directlyor Through Funds

An FHC may acquire or control MBIs directlyor through any subsidiary other than a deposi-tory institution or subsidiary of a depositoryinstitution. An FHC also may not acquire orcontrol MBIs on behalf of a depository institu-tion or subsidiary of a depository institution. A

5. See section 4(l)(2) of the BHC Act (12 U.S.C.1843(l)(2)) and section 225.84 of Regulation Y (12 C.F.R.225.84).

6. See section 4(k)(4)(H) of the BHC Act (12 U.S.C.1843(k)(4)(H)).

7. Concentration in particular industries or in individualinvestments may present supervisory concerns. The Boardexpects all FHCs that engage in MBI activities to establishpolicies governing portfolio diversification and to maintaincapital that is adequate, considering the FHC’s investmentportfolio. See section 3900.0 of this manual and SR-00-9.

Merchant Banking 3907.0


U.S. branch or agency of a foreign bank isconsidered a ‘‘ depository institution’’ for pur-poses of the merchant banking rule and itsrelated restrictions. Accordingly, a U.S. branchor agency of a foreign bank may not acquire orcontrol MBIs, and MBIs may not be acquired orcontrolled on behalf of a U.S. branch or agencyof a foreign bank.

An FHC is allowed to make MBIs through aprivate equity fund or other investment fundthat, in turn, invests in nonfinancial companies.When an FHC makes such an investment, theholding company’s investment in the fund isconsidered an MBI that must comply with therule. Certain benefits for investments in or heldthrough a qualifying private equity fund areprovided, including an extended holding periodand certain relief from the rule’ s cross-marketing restrictions. Investments in funds thatdo not qualify as private equity funds are treatedas any other type of MBI.

3907.0.2.3.2 Definition of PortfolioCompany and Financial HoldingCompany

Some of the rule’s requirements—such as therestrictions on routine management andoperation—apply only to portfolio companies.A ‘‘ portfolio company’’ means any company orentity that is directly or indirectly held, owned,or controlled by an FHC that is using the mer-chant banking authority, and the company orentity is engaged in an activity that is not autho-rized for the FHC under section 4 of the BHCAct. (See section 225.177 of Regulation Y.)

The term ‘‘fi nancial holding company,’’ asused in the rule, refers to the FHC and anydirect or indirect subsidiary of the holding com-pany (including a private equity fund or otherfund controlled by the FHC). The term does notinclude—

1. a portfolio company that is controlled by theFHC or

2. any depository institution controlled by theFHC or any subsidiary of such a depositoryinstitution, unless otherwise provided in therule.

3907.0.3 LIMITS ON MANAGING OROPERATING A PORTFOLIOCOMPANY HELD AS A MERCHANTBANKING INVESTMENT

The GLB Act prohibits an FHC from routinely

managing or operating a portfolio company,except as may be necessary or required to obtaina reasonable return on the resale or dispositionof the investment. (See section 225.171 of Regu-lation Y.)

3907.0.3.1 Relationships That InvolveRoutine Management or Operation

An FHC routinely manages or operates a port-folio company if any director, officer, or employeeof the FHC serves as or has the responsibilitiesof an executive officer of the portfolio company.The term ‘‘ executive officer’’ has the same mean-ing as used in the Board’s Regulation O. Thisdefinition includes any person who participatesor has the authority to participate (other than inthe capacity of a director) in major policymak-ing functions of the portfolio company, whetheror not the officer has an official title, the titledesignates the officer as an assistant, or theofficer serves without salary or other compensa-tion.8 (See section 225.177(d) of Regulation Yand 12 C.F.R. 215.2(e)(1).) An FHC is alsoconsidered to routinely manage or operate aportfolio company if an executive officer of theparent FHC or certain of its major subsidiariesserves as (or has the responsibilities of) an offi-cer or employee of the portfolio company. Forthe purposes of these restrictions, an FHC’smajor subsidiaries include any subsidiary that is(1) a depository institution, (2) an SEC-registered broker-dealer, (3) engaged in MBIactivities or insurance company investmentactivities under section 4(k)(4)(H) or (I) of theBHC Act, (4) a small business investment com-pany, or (5) engaged in significant equity invest-ment activities that are subject to a special capi-tal charge under the Board’s capital guidelines(for example, a company engaged in investmentactivities under section 4(c)(6) or (7) of theBHC Act). An FHC also is considered to rou-tinely manage or operate a portfolio company if

8. An executive officer does not include a person who mayexercise a certain measure of discretion in the performance ofhis or her duties, including the discretion to make decisions inthe ordinary course of business, but who does not participatein the determination of major policies of the company andwhose decisions are limited by policy standards fixed bysenior management. In addition, the term does not include anyperson who is excluded from participating (other than in thecapacity of a director) in major policymaking functions of thecompany by resolution of the board of directors or by thebylaws of the company, provided the person does not in factparticipate in such policymaking functions.



it restricts, by covenants, agreements, or other-wise, the portfolio company’s ability to makeroutine business decisions. Covenants or agree-ments that involve routine business decisionsinclude covenants that restrict the portfolio com-pany’s ability to enter into transactions in theordinary course of business or to hire nonexecu-tive officers or employees. As described below,an FHC may have covenants and agreementsthat restrict actions that are outside the ordinarycourse of business.

In addition, an FHC is presumed to be involvedin the day-to-day management or operations ofa portfolio company if a director, officer, oremployee of the FHC serves as a nonexecutiveofficer or employee of the portfolio company orif an officer or employee of the portfolio com-pany is supervised by or reports to an officer oremployee of the FHC. An FHC may rebut thispresumption by presenting specific facts demon-strating that the junior-officer or employee inter-lock with the portfolio company would notinvolve the investing FHC in the routine man-agement and operating of the company.9 Anyrequest to rebut a presumption must be made tothe Board and should fully describe all the factsand circumstances related to the FHC’s invest-ment in and relationships with the portfoliocompany.

3907.0.3.2 Relationships That Do NotConstitute Routine Management orOperation

The rule identifies several relationships that anFHC may have with a portfolio company thatwould not involve the FHC in routinely manag-ing or operating the portfolio company.10 Thefollowing relationships allow the FHC to moni-tor and provide strategic and financial advice toa portfolio company without becoming involvedin the day-to-day management or operations ofthe company:

1. Director interlocks. An FHC may have oneor more representatives on the board of direc-tors of a portfolio company. The Board con-siders the selection of the partners (includingthe general partner) of a partnership to be theequivalent of selecting the directors of a

company. An FHC representative who servesas a director of a portfolio company mayparticipate fully in those matters that aretypically presented to directors of a com-pany, whether the director participates inthese matters at a meeting of the board, atmeetings of committees of the board, throughwritten votes, through meetings with officersor employees of the portfolio company, or inother ways. The FHC’s director representa-tives, however, may not participate in theday-to-day operations of the portfolio com-pany or in management decisions that aremade in the ordinary course of business andthat are not customarily presented to thedirectors of a company. The portfolio com-pany also must have officers and employeesthat routinely manage and operate the com-pany, and the FHC must not have otherarrangements or relationships with the port-folio company that would involve the FHCin the routine management or operation ofthe portfolio company.

2. Covenants concerning actions outside the or-dinary course of business. An FHC mayrestrict, by covenant or otherwise, the abilityof a portfolio company to take actions thatare outside the ordinary course of business.Some examples of actions that are outsidethe ordinary course of business and that maybe subject to these types of covenants oragreements are—a. the acquisition of significant assets or con-

trol of another company by the portfoliocompany or any of its subsidiaries;

b. the removal or selection of the portfoliocompany’s independent accountant orinvestment banker;

c. significant changes to the portfolio com-pany’s business plan or accounting meth-ods or policies;

d. the removal or replacement of any or allof the executive officers of the portfoliocompany;

e. the redemption, authorization, or issuanceof any equity or debt securities of theportfolio company;

f. any borrowing by the portfolio companythat is outside the ordinary course of busi-ness;

g. the amendment of the portfolio compa-ny’s articles of incorporation, bylaws, orsimilar governing documents; and

h. the sale, merger, consolidation, spin-off,recapitalization, liquidation, dissolution,or sale of substantially all of the assets ofthe portfolio company or any of its signifi-cant subsidiaries.

9. See section 225.171(c) of Regulation Y (12 C.F.R.225.171(c)).

10. See section 225.171(d) of Regulation Y (12 C.F.R.225.171(d)).



3. Providing advisory and underwriting ser-vices to and consulting with a portfolio com-pany. An FHC also may provide financial,investment, or management consulting advi-sory services to the portfolio company inaccordance with applicable limitations underRegulation Y.11 Any management consultingservices provided to a portfolio companymust remain solely advisory, and the FHCmay not assume responsibility for decisionmaking or for the day-to-day management oroperations of the portfolio company.12 AnFHC may also underwrite or act as place-ment agent for the securities of a portfoliocompany and provide assistance to the port-folio company in connection with the under-writing or placement of its securities withoutbeing considered to be involved in routinelymanaging or operating the company. An FHCalso may have regular or periodic meetingswith the officers or employees of a portfoliocompany to monitor and provide adviceregarding the portfolio company’s perfor-mance or activities, so long as the FHC,through such meetings or otherwise, does notroutinely manage or operate the portfoliocompany.

3907.0.3.2.1 Other PermissibleCovenants Not Involving the FHC inRoutinely Managing and Operating aPortfolio Company

Listed below are some additional examples ofcovenants that an FHC may have with a port-folio company without routinely managing oroperating the portfolio company.12a In particu-lar, an FHC may, consistent with the GLB Actand section 225.171(d) of Regulation Y, havecovenants with a portfolio company that restrictthe ability of the portfolio company to—

1. alter its capital structure through the issu-ance, redemption, authorization, or sale ofany equity or debt securities of the portfoliocompany;12b

2. establish the general purpose for funds sought

to be raised through the issuance or sale ofany equity or debt securities of the portfoliocompany (for example, retirement of exist-ing debt, acquisition of another company, orgeneral corporate use);

3. amend the terms of any equity or debt secu-rities issued by the company;

4. declare a dividend on any class of securitiesof the portfolio company or change thedividend-payment rate on any class of secu-rities of the portfolio company;

5. engage in a public offering of securities ofthe portfolio company;

6. register a class of securities of the portfoliocompany under federal or state securitieslaws;

7. list (or de-list) any securities of the port-folio company on a securities exchange;

8. create, incur, assume, guarantee, refinance,or prepay any indebtedness outside the ordi-nary course of business of the portfoliocompany;

9. voluntarily file for bankruptcy, or consentto the appointment of a receiver, liquidator,assignee, custodian, or trustee of the port-folio company for purposes of winding upits affairs;

10. significantly alter the regulatory, tax, or lia-bility status of the portfolio company(examples of actions that would signifi-cantly alter the regulatory, tax, or liabilitystatus of the portfolio company include theregistration of the portfolio company as aninvestment company under the InvestmentCompany Act of 1940, or the conversion ofthe portfolio company from a corporation toa partnership or limited-liability company);

11. make, or commit to make, any capitalexpenditure that isoutside theordinarycourseof business of the portfolio company, suchas the purchase or lease of a significantmanufacturing facility, an office building,an asset, or another company;

12. engage in, or commit to engage in, anypurchase, sale, lease, transfer, or other trans-action outside the ordinary course of busi-ness of the portfolio company, which mayinclude for example—a. entering into a contractual arrangement

(including a property lease or consultingagreement) that imposes significant finan-cial obligations on the portfolio com-pany;

b. the sale of a significant asset of the port-folio company (for example, a signifi-

11. See sections 225.28(b)(6) and 225.86(b)(1) of Regula-tion Y (12 C.F.R. 225.28(b)(6) and 12 C.F.R. 225.86(b)(1)).

12. See sections 225.28(b)(9) and 225.86(b)(1) of Regula-tion Y (12 C.F.R. 225.28(b)(9) and 12 C.F.R. 225.86(b)(1)).

12a. See letter from Virgil Mattingly, the Federal ReserveBoard’s general counsel, to Peter T. Grauer, Credit SuisseFirst Boston, dated December 21, 2001.

12b. For these purposes, the phrase ‘‘equity and debt secu-rities’’ includes options, warrants, obligations, or other instru-ments that give the holder the right to acquire securities of theportfolio company.



cant patent, manufacturing facility, orparcel of real estate);

c. the establishment of a significant newsubsidiary by the portfolio company;

d. the transfer by the portfolio company ofsignificant assets to a subsidiary or to aperson affiliated with the portfolio com-pany; or

e. the establishment by the portfolio com-pany of a significant new joint venturewith a third party;

13. hire, remove, or replace any or all of theexecutive officers of the portfoliocompany;12c

14. establish, accept, or modify the terms of anemployment agreement with an executiveofficer of the portfolio company, includingthe terms setting forth the executive offic-er’s salary, compensation, and severance;

15. adopt or significantly modify the portfoliocompany’s policies or budget concerningthe salary, compensation, or employment ofthe officers or employees of the portfoliocompany generally;

16. adopt or significantly modify any benefitplan covering officers or employees of theportfolio company, including defined bene-fit and defined contribution retirement plans,stock option plans, profit sharing, employeestock ownership plans, or stock apprecia-tion rights plans;

17. alter significantly the business strategy oroperations of the portfolio company, forexample, by entering or discontinuing a sig-nificant line of business or by altering sig-nificantly the tax, cash-management, divi-dend, or hedging policies of the portfoliocompany; or

18. establish, dissolve, or materially alter theduties of a committee of the board of direc-tors of the portfolio company.

Some of the above actions by their very natureare outside the ordinary course of business of aportfolio company and, thus, may be subject toa covenant with the portfolio company. Forexample, covenants restricting the ability of aportfolio company to issue or redeem its equityor debt securities or hire or fire its executiveofficers are unusual actions that typically aretaken only by or in consultation with the compa-ny’s board of directors.

Covenants concerning other types of actionsmay, or may not, involve the FHC in routinebusiness decisions of the portfolio company,depending on the specific scope of actions cov-ered by the covenant and the size and character-istics of the portfolio company. To provideFHCs maximum flexibility in structuring theirrelationships with portfolio companies to theextent permitted by the GLB Act, several of theexamples included above permit an FHC torestrict the ability of a portfolio company totake certain actions whenever the actions aresignificant.

The measure of ‘‘significant’’ in this contextwould depend on the size, capital, condition,business, and other characteristics of the port-folio company. In determining what is signifi-cant for a particular portfolio company, one ruleof thumb is that any action that would, underordinary business practices, be presented to theboard of directors of the portfolio company forapproval or consideration may also be subject toa covenant that requires review and approval ofthe action by the financial holding companyinvestor. In this way, the rule permits a financialholding company investor to exercise the sametype of review and approval rights through acovenant that the FHC could exercise directlythrough representation on the board of directorsof the portfolio company. As with a directorrepresentative, however, an FHC may not use acovenant as a means to become involved inroutine business decisions made in the ordinarycourse of the portfolio company’s day-to-daybusiness activities.

There also may be situations in which a cov-enant is permissible even though the actionsinvolved are ones that, under ordinary businesspractices, would not be considered by the boardof directors of the portfolio company. It isexpected that these situations would be unusualand the permissibility of such a covenant wouldlikely depend on the particular facts and circum-stances involved in the case.

3907.0.3.2.2 FHC May Routinely Manageor Operate a Portfolio Company inSpecial Circumstances

An FHC may routinely manage or operate aportfolio company only when such action is‘‘necessary or required to obtain a reasonablereturn on [the] investment upon resale or dispo-sition.’’ Examples of situations in which inter-vention may be needed would be when theportfolio company experiences a significantoperating loss or when there is a loss of senior

12c. The term ‘‘executive officer’’ is defined in section225.171 of Regulation Y.



management. Once the FHC has taken appropri-ate action to obtain a reasonable return on theresale or disposition of the investment, the GLBAct requires the FHC to cease routinely manag-ing or operating the portfolio company. TheFHC may routinely manage or operate a port-folio company only for the period of time thatmay be necessary to address the cause of theholding company’s involvement in the routinemanagement or operations of the portfolio com-pany, to obtain suitable management arrange-ments, to dispose of the investment, or to other-wise obtain a reasonable return on the resale ordisposition of the investment. The determina-tion of whether and how long FHC interventionis necessary or required will depend on the factsand circumstances of the particular investment.

Two requirements in the rule assist the Fed-eral Reserve in monitoring the interventions ofFHCs in the routine management or operationsof portfolio companies. These requirementsensure that such actions are consistent with theGLB Act’s limitations. First, FHCs are requiredto maintain and make available to the Board onrequest a written record describing the compa-ny’s involvement in routinely managing or oper-ating any portfolio company.13 Second, an FHCis required to provide the Board with writtennotice if the company routinely manages oroperates a portfolio company for more than ninemonths.14 The notice may be in the form of aletter and should identify the portfolio company,the date on which the FHC first became involvedin the routine management or operations of theportfolio company, the reasons for the involve-ment, and the actions that the FHC has taken toaddress the circumstances giving rise to theintervention, as well as provide an estimate ofwhen the FHC anticipates it will cease routinelymanaging or operating the portfolio company.

3907.0.3.3 Depository InstitutionsProhibited from Managing or OperatingPortfolio Companies

A depository institution or a subsidiary of adepository institution may not routinely manageor operate a portfolio company held by an FHC.As noted above, U.S. branches and agencies offoreign banks are considered depository institu-tions for purposes of the rule. A director, officer,or employee of a depository institution or its

subsidiary, as well as a U.S. branch or agency,however, is not prohibited from serving as adirector of a portfolio company to the sameextent as would be permitted for a director,officer, or employee of an FHC. Such director,officer, or employee is also not prohibited fromtaking other actions that the rule does not defineto be routine management or operation. In addi-tion, a depository institution is not preventedfrom having covenants or from taking actionspursuant to covenants that are typically found incredit agreements to ensure repayment of exten-sions of credit in the ordinary course of busi-ness, provided the covenant or action is not anattempt to evade the rule’s restrictions.

The rule also does not apply the prohibitionon a depository institution routinely managingor operating a portfolio company to a financialsubsidiary of a bank that is held in accordancewith section 5136A of the Revised Statutes (12U.S.C. 24a) or section 46 of the Federal DepositInsurance Act (FDI Act). The prohibition alsodoes not apply to a small business investmentcompany subsidiary of a bank held in accor-dance with the Small Business Investment Actof 1958. These subsidiaries may, however,exercise routine management or operation onlyin accordance with the limitations that apply toFHCs.

3907.0.4 HOLDING PERIODS FORMERCHANT BANKINGINVESTMENTS

The GLB Act requires that any shares, assets,and ownership interests acquired as an MBI beheld only for a period of time that enables thesale or disposition of the interest on a reason-able basis, consistent with the financial viabilityof the FHC’s merchant banking activity. Therule permits an FHC to hold any MBI for aperiod of up to 10 years. In addition, the ruleallows an FHC to own or control an MBI in orthrough a private equity fund (as defined below)for the life of the fund, up to 15 years.15

An FHC may hold an MBI beyond the rule’sspecified time periods only with the Board’sprior approval. A request by an FHC for anextension of the applicable holding period mustbe filed at least 90 days before the expiration ofthe holding period. An extension request mustprovide the reasons for the request (including

13. See section 225.171(e)(4) of Regulation Y (12 C.F.R.225.171(e)(4)).

14. See section 225.171(e)(3) of Regulation Y (12 C.F.R.225.171(e)(3)).

15. See section 225.172 of Regulation Y (12 C.F.R. 225.172).


BHC Supervision Manual June 2002Page 6.1

the factors listed below), explain the FHC’s planfor divesting the investment, and discuss thefactors that the Board may consider in review-ing the request. Factors to be included in theextension request are the cost to the FHC ofdisposing of the investment within the applica-ble time period, the total exposure of the FHC tothe portfolio company and the risks that dispos-ing of the investment without an extension maypose to the FHC, market conditions, the natureof the portfolio company’s business, the extentand history of the FHC’s involvementin the management and operations of the port-folio company, and the average holding periodof the FHC’s MBIs. The Board may also con-sider any other relevant information related tothe investment.

If an FHC receives permission to hold anMBI beyond the applicable holding period, aspecial capital charge applies to the investment.The Board must set this charge at a rate that isabove the highest marginal tier 1 capital chargeapplicable under the Board’s capital guidelinesfor MBIs held by that FHC, but the rate may notbe below 25 percent of the adjusted carryingvalue of the investment as reflected on theFHC’s balance sheet. The Board may also imposeother restrictions it determines to be appropriatein connection with granting the extensionrequest.

3907.0.4.1 Holding-Period TackingProvisions

The rule includes special ‘‘tacking’’ provisionsto prevent an FHC from circumventing the hold-ing periods on MBIs by transferring an MBIfrom one company or fund to another.16 Therule also provides that, for purposes of calculat-ing compliance with the merchant banking hold-ing periods, an investment the FHC acquiresunder another authority that imposes a restric-tion on the amount of time that the FHC mayhold the investment is considered to have beenacquired on the original acquisition date.

3907.0.5 PRIVATE EQUITY FUNDS

As noted above, the rule permits an FHC tomake MBIs directly or through funds that pool

the firm’s capital with capital provided by third-party investors, such as investment companies,pension funds, endowments, financial institu-tions or corporations, and sophisticated indi-vidual investors who have a high net worth.Frequently, these pooled investment vehicleshave characteristics (such as limited terms,manager-compensation arrangements, and thepresence of third-party investors that monitorinvestments) that encourage the fund to disposeof its investments in a relatively short period oftime. Considering such characteristics, and to

16. See section 225.172(b)(2) and (3) of Regulation Y (12C.F.R. 225.172(b)(2) and (3)).


BHC Supervision Manual June 2002Page 6.2

accommodate industry practice on investmentfunds, the rule includes several special provi-sions for MBI activities conducted through aqualifying ‘‘ private equity fund.’’ The provi-sions include a longer holding period for privateequity fund investments, a higher aggregateinvestment threshold for review of an organiza-tion that makes investments in or through pri-vate equity funds, and streamlined reporting andrecordkeeping provisions for investments in orheld through private equity funds.

3907.0.5.1 Definition of Private EquityFund

To qualify as a ‘‘ private equity fund’’ under therule, the fund must have a fixed duration of notmore than 15 years including all potential exten-sions, and the FHC (including its officers, direc-tors, employees, and principal shareholders) maynot own more than 25 percent of the total equityof the fund. There are no limits on advisory feesor on the various types of incentive compensa-tion that the FHC may receive for services ren-dered to the fund, provided such fees do notincrease the FHC’s equity stake in the fundabove the 25 percent threshold.

A private equity fund also may not be anoperating company and must be engaged exclu-sively in the business of investing in financialand nonfinancial companies for resale or otherdisposition. In addition, the fund may not beestablished or operated for the purpose of mak-ing investments that are inconsistent with sec-tion 4(k)(4)(H) of the BHC Act or evading thelimitations of the GLB Act or the rule.

A private equity fund can be organized in anyform, including a partnership, corporation, orlimited-liability company. In addition, the fundmay, but need not be, registered as an invest-ment company under the federal securities laws.

3907.0.5.2 Permissible Holding Periodfor Private Equity Fund Investments

As noted above, an FHC, without Board approval,may own or control an investment in a privateequity fund that makes MBIs for the duration ofthe fund, which may be up to 15 years. Aqualifying private equity fund may thereforehold investments in portfolio companies for upto 15 years, and it is not required to dispose ofits investments within the 10-year period appli-cable to other types of MBIs. In special circum-stances, an FHC may seek the Board’s approval

to retain an investment in a qualifying privateequity fund or to extend the duration of a privateequity fund for a period longer than 15 years.17

(See section 3907.0.5 of this manual for a dis-cussion of how an FHC may request an exten-sion of this holding period.)

3907.0.5.3 Routine Management andOperation Restrictions for Private EquityFunds

The GLB Act and the rule generally prohibit anFHC from routinely managing or operating anyportfolio company—that is, any companyengaged in nonfinancial activities.18 Theserestrictions apply regardless of whether the FHCowns or controls its interest in the portfoliocompany directly or through a private equityfund. Accordingly, an FHC may not routinelymanage or operate a portfolio company that isowned or controlled by a private equity fund inwhich the FHC owns or controls any ownershipinterest, except in the limited circumstances per-mitted by the rule.19 In addition, if an FHCcontrols a private equity fund, the private equityfund is a subsidiary of the FHC and the privateequity fund must abide by the rule’s limits onroutine management and operation of portfoliocompanies. An FHC, however, is not prohibitedfrom routinely managing or operating the pri-vate equity fund itself.

An FHC is considered to control a privateequity fund for the purpose of the rule if theFHC or any director, officer, employee or princi-pal shareholder of the company (1) serves as ageneral partner, managing member, or trustee ofthe private equity fund; (2) owns or controls inthe aggregate 25 percent or more of any class ofvoting shares or similar interests in the fund;(3) selects, controls, or constitutes a majority ofthe directors, trustees, or management of thefund; or (4) owns or controls more than 5 per-cent of any class of voting shares or similarownership interests in the fund and serves as thefund’s investment adviser.

17. The holding-period tacking rules in section 225.172(b)(2)and (3) of Regulation Y must be applied when a private equityfund investment has been held longer than the permitted time.

18. See sections 225.177(c) and 225.171(a) of RegulationY (12 C.F.R. 225.177(c) and 225.171(a)).

19. See section 225.171(e) of Regulation Y (12 C.F.R.225.171(e)).



3907.0.5.4 Other Matters Related toPrivate Equity Funds

When an FHC has a passive (that is, noncontrol-ling) investment in a private equity fund that isadvised and controlled by an unaffiliated entity,any shares owned by the fund generally are notconsidered to be owned or controlled by thepassive FHC investor.20 Therefore, the rule’scross-marketing restrictions on the products orservices of a portfolio company, the limitationsof sections 23A and 23B of the FRA, and therule’s reporting and recordkeeping requirementsdo not apply to investments in portfolio compa-nies that are held by a private equity fund andthat are not controlled by the FHC. Theserestrictions and requirements (other than thecross-marketing restrictions) would, however,apply to the FHC’s investment in the privateequity fund and would govern the relationshipof the FHC with the private equity fund.

3907.0.5.4.1 Funds That Are NotQualifying Private Equity Funds

An FHC is permitted to invest in and control afund that does not meet the private equity funddefinition. If the FHC controls the nonqualify-ing fund, then the provisions of the rule, includ-ing the holding-period provisions for portfoliocompanies, the routine-management restrictions,the risk-management and recordkeeping require-ments, the cross-marketing provisions, and thesection 23A provisions, apply to investmentsmade by the nonqualifying fund in the samemanner as those provisions would apply if theinvestment in the portfolio company were helddirectly by the FHC. If the FHC owns a noncon-trolling interest in the fund, then the fund isitself considered to be a portfolio company.

An FHC may thus own more than 25 percentof the equity of a fund that has an unlimited life(and, consequently, is not a qualifying privateequity fund), so long as the fund does not holdinvestments in portfolio companies for morethan 10 years, and the FHC and the fund complywith the routine management and other restric-tions of the rule. Similarly, an FHC may investin a fund that, in addition to making MBIs,

engages in other businesses (and, consequently,is not a qualifying private equity fund), so longas the FHC does not control the fund, divestsits interest in the fund within 10 years, andcomplies with the other provisions of the rulethat apply to investments in a portfoliocompany.

3907.0.6 TEMPORARY AGGREGATEINVESTMENT THRESHOLDS FORMBIs

To allow the Federal Reserve to review therisk-management policies, procedures, and sys-tems of an FHC that seeks to devote a signifi-cant portion of its capital to MBIs, temporaryinvestment thresholds on MBIs are included inthe rule. An FHC may not, without the Board’sprior approval, make additional MBIs if theaggregate carrying value of its existing MBIsexceeds either of the two thresholds. The firstthreshold prevents an FHC from making addi-tional MBIs (including making additional capi-tal contributions to a company held under therule) if the aggregate carrying value of theFHC’s MBIs exceeds 30 percent of the FHC’stier 1 capital. A second threshold applies if theaggregate carrying value of the FHC’s MBIs,excluding investments in private equity funds,exceeds 20 percent of the FHC’s tier 1 capital.An FHC may exceed either threshold with theprior approval of the Board.

The investment thresholds were adopted assunset provisions until the Board adopts a finalrule specifically addressing the regulatory capi-tal treatment for MBIs and that rule becomeseffective. In February 2001, the Board, the Officeof the Comptroller of the Currency, and theFederal Deposit Insurance Corporation jointlyrequested comment on proposed rules that wouldestablish special capital requirements for MBIsand similar equity investments held by BHCsand banks. (See 66 Federal Register 10, 212(February 14, 2001).)

The investment thresholds discussed aboveapply only to MBIs made by FHCs under sec-tion 4(k)(4)(H) of the BHC Act and under therule. They do not apply to or restrict invest-ments made by BHCs or FHCs under otherauthorities, such as investments made throughsmall business investment companies (SBICs),investments made in less than 5 percent of thevoting shares of a company under section 4(c)(6)or (7) of the BHC Act, or investments madeoverseas under Regulation K.

20. Seesection2(g)(1)of theBHCAct (12U.S.C.1841(g)(1))and section 225.2(e)(2)(i) of Regulation Y (12 C.F.R.225.2(e)(2)(i)).



3907.0.7 RISK-MANAGEMENT,REPORTING, AND RECORDKEEPINGPOLICIES

3907.0.7.1 Policies, Procedures, Systems,and Reports

An FHC must maintain policies, procedures,and systems that are reasonably designed tomanage the risks associated with making MBIsand to monitor compliance with the statutoryand regulatory provisions governing such invest-ments. The rule identifies the major areas thatmust be addressed by the internal policies andcontrols of an FHC engaged in making MBIs. Inparticular, an FHC engaged in merchant bank-ing activities must have policies, procedures,records, and systems that are reasonably designedto—

1. monitor and assess the carrying value, mar-ket value, and performance of MBIs and ofthe company’s aggregate MBI portfolio;

2. identify and manage the market, credit, con-centration, and other risks associated withMBIs;

3. identify, monitor, and assess the terms,amounts, and risks arising from transactionsand relationships (including contingent feesor contingent interests) with each companyin which the FHC has an MBI;

4. ensure the maintenance of corporate sepa-rateness between the FHC and each companyin which the FHC holds an interest under therule, and protect the FHC and its depositoryinstitution subsidiaries from legal liabilityfor the operations conducted and financialobligations of any such company; and

5. ensure compliance with the rule, includingthe rule’s holding-period, routine manage-ment and operation, and cross-marketingrestrictions, as well as with any other appli-cable provisions of law governing transac-tions and relationships with companies inwhich the FHC holds an interest under therule, such as fiduciary principles and sections23A and 23B of the FRA.

This list of policies, procedures, records, andsystems identifies only some of the most impor-tant elements of a sound approach to monitoringMBI activities. The Board has issued supervi-sory guidance (see SR-00-9) that provides addi-tional detail concerning the internal controls,policies, and systems that any BHC engaged inequity investment activities is expected to haveand maintain to engage in such activities in a

safe and sound manner. (See section 3900.0 ofthis manual for more detail on this guidance.)

If the FHC controls a private equity fund orother fund that makes MBIs, the FHC mustensure that the fund has the types of policies,procedures, and systems for making and moni-toring MBIs that are required for FHCs. TheFHC may satisfy these requirements by ensur-ing that the private equity fund or other fund issubject to the FHC’s merchant banking policies,procedures, and systems. If an FHC does notcontrol the fund, then the fund is not subject tothe recordkeeping and risk-management provi-sions of the rule. Nevertheless, an FHC mustapply its merchant banking policies, procedures,and systems to any investment made by thecompany in any fund that is controlled by anunaffiliated entity.

It is anticipated that FHCs will be able tosatisfy the rule’s recordkeeping requirements byusing the internal reports and records it preparesin the ordinary course of making an MBI orcontrolling a private equity fund. Similarly, if anFHC makes a noncontrolling investment in aprivate equity fund, the FHC should be able touse information provided by the fund’s adviseror sponsor to satisfy the rule’s recordkeepingrequirements.

3907.0.7.2 Notice of Commencement ofMerchant Banking Activities

An FHC must notify the Board within 30 daysof commencing merchant banking activities undersection 4(k)(4)(H) of the BHC Act. (See section225.87(a) of Regulation Y.) For a domesticFHC, this notice should be provided on theFederal Reserve’s reporting form, the FR Y-6A(which is expected to be replaced by the FRY-10). For qualifying foreign banking organiza-tions, the notice should be provided on the FRY-7 (which is expected to be replaced by the FRY-10F).

The appropriate Reserve Bank, in coordina-tion with Board staff, should schedule a reviewof the investment and risk-management poli-cies, procedures, and systems of an FHC thatfiles a notification indicating that it has com-menced merchant banking activities. The reviewmay be conducted either off- or on-site, depend-ing on the expected level and complexity of theFHC’s MBIs and the company’s previous expe-rience in making equity investments under otherlegal authorities. This review may be deferred



until the next regularly scheduled inspection orexamination, if the FHC has significant experi-ence in making equity investments under pre-existing authorities and if the Federal Reservehas recently reviewed the company’s policies,procedures, and systems for managing and con-trolling the risks associated with equity invest-ment activities.

3907.0.7.3 Quarterly and AnnualReporting Requirements

The Federal Reserve has instituted two periodicreporting requirements relating to MBIs. Thefirst is a quarterly report (FR Y-12) that seeksaggregate information on the cost and carryingvalues of an FHC’s MBIs. This report alsocollects informationonnonfinancial equity invest-ments made by BHCs and their subsidiariesunder other legal authorities, including invest-ments made through SBICs and investmentsmade in less than 5 percent of the voting sharesof a company under section 4(c)(6) or (7) of theBHC Act. This quarterly report assists the Fed-eral Reserve in monitoring the exposure ofBHCs to MBIs and similar types of equityinvestments. The second report is an annualreport, the FR Y-12A, that will collect basicinformation on MBIs held by an FHC for anextended time period. The FR Y-12A annualreport collects information on MBIs that areapproaching the end of their applicable holdingperiod.

3907.0.7.4 Notice of Large MerchantBanking Acquisitions

After an FHC has provided notice to the FederalReserve that it has commenced merchant bank-ing activities, the FHC generally is not requiredto file a notice after acquiring the shares of acompany under its merchant banking invest-ment authority. However, an FHC must file apost-transaction notice with the Federal Reservewithin 30 days after making an MBI in a com-pany if (1) the investment represents more than5 percent of the voting shares, assets, or owner-ship interests of the company, and (2) the totalcost of the investment to the FHC exceeds thelesser of 5 percent of the tier 1 capital of theFHC or $200 million. This notice must be pro-vided on the forms discussed above.

3907.0.8 CROSS-MARKETINGRESTRICTIONS

The GLB Act prohibits a depository institutionsubsidiary of an FHC from marketing or offer-ing any product or service of a company inwhich the FHC has an MBI. Similarly, the GLBAct prohibits a company held by an FHC as anMBI from marketing or offering any product orservice of a depository institution subsidiary ofthe FHC. U.S. branches and agencies of a for-eign bank that conduct BHC activities in theUnited States or through a U.S. company areconsidered depository institutions under the rule.Thus, a U.S. branch or agency of a foreign bankmay not cross-market the products or servicesof a company that is owned or controlled by theforeign bank or an affiliate of the foreign bankunder section 4(k)(4)(H) of the BHC Act. Inaddition, the cross-marketing restrictions gener-ally apply to any subsidiary of a depositoryinstitution controlled by an FHC.

The cross-marketing restrictions, however, donot apply to certain subsidiaries of a depositoryinstitution that Congress has expressly autho-rized the parent institution to own or control. Inparticular, the cross-marketing restrictions donot apply to (1) a financial subsidiary of adepository institution held in accordance withsection 5136A of the Revised Statutes (12 U.S.C.24a) or section 46 of the FDI Act, (2) anycompany held by an Edge Act or agreementsubsidiary of the depository institution that iscontrolled pursuant to section 25 or 25A of theFRA, or (3) any company held by an SBICsubsidiary of the depository institution that iscontrolled in accordance with the Small Busi-ness Investment Act.

The cross-marketing restrictions of the GLBAct and the rule also do not apply to nondeposi-tory affiliates of FHCs. Accordingly, a nonde-pository holding company affiliate of an FHCmay engage in cross-marketing activities with aportfolio company held by the FHC under sec-tion 4(k)(4)(H) of the BHC Act. In addition,these restrictions do not apply to (1) portfoliocompanies in which the FHC, either directly orindirectly, owns less than 5 percent of the votingshares or ownership interests; (2) portfolio com-panies that are held by a private equity fund theFHC does not control; and (3) interests in aprivate equity fund (whether or not the FHCcontrols the fund). Accordingly, a depositoryinstitution subsidiary of an FHC may engage incross-marketing activities with such a company,or it may market the shares of a private equityfund.



3907.0.8.1 Marketing Products orServices Involving a Portfolio Company

As noted above, the GLB Act prohibits anydepository institution controlled by an FHCfrom (1) marketing or offering any product orservice of a portfolio company held by the FHCunder section 4(k)(4)(H) of the BHC Act or (2)allowing any product or service of the deposi-tory institution to be offered or marketed by orthrough any portfolio company held by the FHCunder that section. A depository institution orsubsidiary of a depository institution is not pro-hibited from marketing its own products orservices—such as deposit, lending, and advisoryproducts or services—to a portfolio company solong as the portfolio company does not thenmarket those products or services to its custom-ers or others. A depository institution subsidiaryof an FHC also may purchase the products orservices of a portfolio company—such as dataprocessing hardware, software, or services tosupport the depository institution’ s ownoperations—provided that the institution doesnot, directly, indirectly, or through any arrange-ment, market the portfolio company’s productsor services to the institution’s customers or oth-ers. Likewise, the cross-marketing restrictionswould not prohibit a depository institution con-trolled by an FHC from engaging in cross-marketing activities with a company that is aco-investor with the FHC in a portfolio com-pany, so long as those activities do not involveproducts or services of the portfolio company.

3907.0.9 PRESUMPTION OFCONTROL UNDER SECTIONS 23AAND 23B OF THE FRA

Sections 23A and 23B of the FRA impose spe-cific quantitative, qualitative, and collateralrequirements on certain types of transactionsbetween an insured depository institution and itsaffiliates, that is, companies that are under com-mon control with the insured depository institu-tion. Typically, a company owned by an FHC isconsidered to be an affiliate of the FHC’s sub-sidiary insured depository institution for the pur-poses of sections 23A and 23B, if the FHCowns or controls 25 percent or more of anyclass of the company’s voting securities. TheGLB Act, however, includes a presumption thatan FHC controls a company for purposes ofsections 23A and 23B if the FHC directly orindirectly, or acting through one or more otherpersons, owns or controls 15 percent or more of

the equity capital of the company under themerchant banking authority of section 4(k)(4)(H)of the BHC Act.21 Thus, a company is presumedto be a section 23A affiliate of a subsidiaryinsured depository institution of an FHC if theFHC owns or controls more than 15 percent ofthe total equity of the company under section4(k)(4)(H).

An FHC can rebut the presumption by provid-ing information to the Board demonstrating thatthe FHC does not control the company.22 In thethree situations identified below, the presump-tion of control under the GLB Act will be con-sidered rebutted. In each situation, the FHC isassumed to own more than 15 percent of thetotal equity of the portfolio company under sec-tion 4(k)(4)(H) of the BHC Act (thereby trigger-ing the statutory presumption) and less than25 percent of any class of voting securities ofthe portfolio company (thereby not meeting thestatutory definition of control). In particular,absent evidence to the contrary, an FHC will notbe presumed to control a portfolio company if—

1. no officer, director, or employee of the FHCserves as a director, trustee, or general part-ner (or as an individual exercising similarfunctions) of the portfolio company;

2. a person that is not affiliated or associatedwith the FHC owns or controls a greaterpercentage of the equity capital of the port-folio company than the FHC, and no morethan one officer or employee of the holdingcompany serves as a director or trustee (or asan individual exercising similar functions) ofthe portfolio company; or

3. a person that is not affiliated or associatedwith the FHC owns or controls more than50 percent of the voting shares of the port-folio company, and officers and employeesof the FHC do not constitute a majority ofthe directors or trustees (or of individualsexercising similar functions) of the portfoliocompany.

21. Equity capital includes voting and nonvoting shares,warrants, options, and other instruments convertible intoequity capital.

22. The presumption applies only when an FHC owns orcontrols 15 percent or more of the total equity of a portfoliocompany under section 4(k)(4)(H) of the BHC Act and therule. Under existing Board precedents, an FHC may not ownany shares of a company in reliance on section 4(c)(6) or (7)of the BHC Act when the company owns or controls, in theaggregate under a combination of authorities, more than 5percent of any class of voting securities of the company.



These safe harbors do not require Board reviewor approval under the provisions allowing rebut-tal of the presumptions. An FHC also mayrequest the Board’s approval to rebut a pre-sumption of control under other circumstances.

The rule’s presumption of control is indepen-dent from the general definition of control insection 23A of the FRA.23 A portfolio company,under the statute, is per se a section 23A affiliateof any insured depository institution subsidiaryof an FHC if the FHC owns 25 percent or moreof a class of voting securities of the portfoliocompany, even if the FHC owns or controls lessthan 15 percent of the portfolio company’s totalequity or is within one of the rule’s safe harbors.

For the purpose of applying the presumptionof control, an FHC that has an investment in aprivate equity fund will not be considered toindirectly own the equity capital of a portfoliocompany held by the fund unless the FHC con-trols the private equity fund. For example, if anFHC has a noncontrolling investment in a pri-vate equity fund that, in turn, owns 20 percentof the total equity of a portfolio company, theportfolio company is not presumed to be anaffiliate of the insured depository institution sub-sidiaries of the FHC. On the other hand, if anFHC acts as general partner of a private equityfund and thus controls the fund, and if theprivate equity fund owns or controls more than

15 percent of the total equity of any portfoliocompany, the portfolio company is presumed tobe an affiliate of the insured depository institu-tion subsidiaries of the FHC.

To ensure competitive equity, the Board’srule applies sections 23A and 23B of the FRA tocovered transactions between a U.S. branch oragency of a foreign bank and (1) any portfoliocompany controlled by the foreign bank or anaffiliate of the foreign bank under the merchantbanking authority of section 4(k)(4)(H) of theBHC Act, and (2) any company controlled bythe foreign bank or an affiliate if the company isengaged in making MBIs under section 4(k)(4)(H)and the proceeds of the covered transaction areused for the purpose of funding the company’smerchant banking activities. In determining if aportfolio company is controlled by a foreignbank or an affiliate of a foreign bank for thesepurposes, the rebuttable presumption of controland the three safe harbors discussed above applyto the foreign bank and affiliate in the samemanner that the presumption and safe harborsapply to domestic FHCs. The rule does notrestrict lending by a foreign bank’s U.S. branchesand agencies to parent companies or other affili-ated companies unless the proceeds of suchlending would be used by these companies tomake or fund the making of MBIs.

23. See 12 U.S.C. 371c(3)(A).





Merchant banking investmentactivities

1843(k)(7)(A)

Permitted investments 225.170 4-058

Limitations on managing or operatinga portfolio company held as an MBI

225.171 4-058.2

MBI holding periods 225.172 4-058.3

Investments in private equity fund 225.173 4-058.4

Aggregate limits on MBIs 225.174 4-058.5

Risk-management, reporting, andrecordkeeping policies for MBIs

225.175 4-058.6

Cross-marketing and FRA section 23Aand 23B limitations for MBIs

225.176 4-058.7

Definitions 225.177 4-058.8





Supervisory Guidance on Equity Investment and MerchantBanking Activities (Section 4(k) of the BHC Act) Section 3909.0

Investments in the equity of nonfinancial com-panies1 as well as lending to private-equity-financed companies have emerged as importantsources for earnings and business relationshipsat a number of banking organizations (BOs).2These equity investments in nonfinancial com-panies, however, can entail significant market,liquidity, and other risks. Equity investmentscan also give rise to increased volatility of bothearnings and capital. Accordingly, sound invest-ment and risk-management practices and strongcapital positions are critical when conductingthese activities.

In June 2000, the Board issued supervisoryguidance on various sound practices related tothe equity investment activities of B0s; thisguidance merits the attention of management,examiners, and other supervisory staff. The guid-ance applies to the equity investment activitiesof financial holding companies (FHCs), bankholding companies (BHCs), state member banks,and their affiliates, regardless of the authorityunder which the investments are made. Themajor elements of this guidance, equity invest-ments and the provision of traditional credit-based services to equity-funded companies, arehighlighted below. For a more complete discus-sion, see SR-00-9.

3909.0.1 LEGAL AND REGULATORYAUTHORITY FOR EQUITYINVESTMENTS

FHCs, BHCs, and depository institutions areable to make equity investments under severalstatutory and regulatory authorities. Under sec-tion 4(c)(6) and (7) of the Bank Holding Com-pany Act (BHC Act), BHCs may make passive

investments in up to 5 percent of the outstand-ing voting shares of any company and up to25 percent of the total equity of the company.Under this authority, there is no aggregate limiton the total dollar amount of equity investmentsthat a BHC may hold.

BOs can make equity investments through asmall business investment corporation (SBIC),which can be a subsidiary of a bank or BHC.Investments made by SBIC subsidiaries areallowed up to a total of 50 percent of a portfoliocompany’s outstanding shares, but can only bemade in companies defined as a small business,according to SBIC rules. A bank’s aggregateinvestment in the stock of SBICs is limited to5 percent of the bank’s capital and surplus. Inthe case of BHCs, the aggregate investment islimited to 5 percent of the BHC’s proportionateinterest in the capital and surplus of its subsidi-ary banks.

Under Regulation K, which implements sec-tions 25 and 25A of the Federal Reserve Act(FRA) and section 4(c)(13) of the BHC Act,BOs may, with Board approval, make portfolioinvestments in foreign companies that in theaggregate do not exceed 25 percent of the tier 1capital of the BHC. In addition, individual invest-ments must be less than 20 percent of a portfoliocompany’s voting shares and must not exceed40 percent of the portfolio company’s totalequity.3

FHCs are also permitted to acquire any amountof the shares, assets, or ownership interests of anonfinancial company under the merchant bank-ing investment authority of section 4(k)(4)(H)of the BHC Act, as amended by the Gram-Leach-Bliley Act (GLB Act). The GLB Actplaces certain limits on the holding period ofmerchant banking investments and on the abil-ity of an FHC to routinely manage or operate aportfolio company held as a merchant bankinginvestment. Subpart J of the Board’s RegulationY (12 C.F.R. 225.170–225.177) implements theseand other restrictions applicable to merchantbanking investments.

Equity investments made under any of theauthorities described above may be in publicly

1. Unless otherwise noted, references to equity invest-ments in this guidance are references to equity investments innonfinancial companies. Nonfinancial companies include com-panies that engage in activities other than financial activitiesthat a financial holding company may conduct pursuant tosection 4 of the Bank Holding Company Act (12 U.S.C.1843), as amended by the Gramm-Leach-Bliley Act, and theregulations and interpretations thereunder. Equity investmentsinclude merchant banking investments made by financialholding companies under the regulations adopted by the Boardof Governors (12 C.F.R. 225, subpart J, sections 225.170through 225.177) and the Treasury Department (12 C.F.R.,chapter XV, part 1500, sections 1500.1 through 1500.8) thatbecame effective on February 15, 2001.

2. The term ‘‘private equity,’’ as used in this guidance,refers to shared-risk investments outside of publicly quotedsecurities and also activities such as venture capital, leveragedbuyouts, mezzanine financing, and holdings of publicly quotedsecurities obtained through these activities.

3. Also included in calculating a BO’s investment areshares of the corporation held in trading or dealing accountsor under any other authority. The 25 percent of tier 1 capitallimitation increases to 100 percent of tier 1 capital for certainnon-BHC investors. See Regulation K for more detailedinformation.


traded securities or privately held equity inter-ests. The investment may be made as a directinvestment in a specific portfolio company, or itmay be made indirectly through a pooled invest-ment vehicle, such as a private equity fund. Ingeneral, private equity funds are investmentcompanies, typically organized as limited part-nerships, that pool capital from third-partyinvestors to invest in shares, assets, and owner-ship interests in companies for resale or otherdisposition.4 Private equity fund investmentsmay provide seed or early-stage investmentfunds to start-up companies, or they may financechanges in ownership, middle-market businessexpansions, and mergers and acquisitions.

The supervisory guidance applies to all equityinvestments a BHC or FHC holds in nonfinan-cial companies, public or private, regardless ofthe authority under which such investments aremade. FHCs and BHCs are expected to controlaggregate risk exposures on a consolidated basis,while recognizing legal distinctions and pos-sible obstacles to cash movements among sub-sidiaries and affiliates. Also, the basic principlesset forth in this guidance should be incorporatedinto the U.S. operations of foreign BOs, withappropriate adaptations to reflect the fact that(1) those operations are an integral part of aforeign bank, which should be managing itsrisks on a consolidated basis, and (2) the foreignbank is subject to overall supervision by itshome authorities.

3909.0.2 SOUND PRACTICES FOREQUITY INVESTMENTS

High returns in both equity investments andlending to private-equity-financed companiescan spur an increased flow of funds into thismarket segment. As in other rapidly expandingand highly profitable business lines, businessand competitive pressures can lead to compro-mises in due diligence, the use of overly opti-mistic assumptions, and breakdowns in internalcontrols. Sound investment and risk-management practices are crucial to the successof equity investment activities. As with anyfinancial activity, sound management practicesfor these activities involve—

1. active involvement and oversight by the boardof directors and senior management;

2. appropriate policies, limits, procedures, andmanagement information systems that gov-ern all elements of the investment decision-making and management process; and

3. adequate internal controls.

As with all financial activities, institutionsshould ensure that they have sufficient capitalfor conducting equity investment activities. BOsthat are conducting material equity investmentactivities are expected to have an internal capital-allocation system that meaningfully links theidentification, monitoring, and evaluation of therisks of the institution’s equity investmentactivities to the determination of its needs foreconomic capital. (See SR-99-18.) A review ofthese systems should be an important part of theinvestment-management process, as well as anintegral element of ongoing supervisory reviewand monitoring of this business line. The federalbanking agencies have recognized that equityinvestment activities entail greater risks thantraditional banking activities, and they haverequested comment on proposed amendments totheir regulatory capital guidelines that wouldestablish special capital requirements for equityinvestments.5

Supervisory approach. Examiners and othersupervisors (and a BO’s management) shouldreview each of the three areas listed above toidentify any deficiencies in the management ofFHCs and BHCs. The supervisory efforts shouldbe targeted appropriately in accordance withFederal Reserve policies on risk-focused super-vision, taking into account both (1) the findingsof internal audit and other independent reviewsand (2) the materiality of equity investmentactivities to the banking organization. Consis-tent with the Federal Reserve’s role as umbrellasupervisor, reviews of the merchant bankingactivities of FHCs and the equity investmentactivities of BHCs should focus on the potentialexposure these activities may pose to insureddepository affiliates and should, where appropri-ate and available, use the findings of primarybank supervisors and functional regulators ofholding company affiliates. At the same time,supervisory and examination staff should ensurethat they continue to conduct sufficient and tar-geted transaction testing across legal-entity linesif necessary to fully assess the adequacy ofbusiness-line risk management. Transaction test-ing should be consistent with the risk profile ofthe institution and the materiality of the activityto the institution’s financial condition.

4. For a detailed definition of ‘‘private equity funds,’’ seethe merchant banking rule (12 C.F.R. 225.170 et seq.).

5. See 66 Federal Register 10, 212 (Feb. 14, 2001).

Supervisory Guidance on Equity Investment and Merchant Banking Activities 3909.0


3909.0.2.1 Oversight by the Board ofDirectors and Senior Management

Equity investment activities require the activeoversight of the board of directors and seniormanagement of the institution that is conductingthe activities. The board should approve port-folio objectives, overall investment strategies,and general investment policies that are consis-tent with the institution’s financial condition,risk profile, and risk tolerance. Portfolio objec-tives should address the types of investments,expected business returns, desired holdingperiods, diversification parameters, and otherelements of sound investment-management over-sight. Board-approved objectives, strategies,policies, and procedures should be documentedand clearly communicated to all the personnelinvolved in their implementation. The boardshould actively monitor the performance andrisk profile of equity investment business linesin light of the established objectives, strategies,and policies.

The board of directors should also ensure thatthere is an effective management structure forconducting the institution’s equity activities,including adequate systems for measuring, moni-toring, controlling, and reporting on the risks ofequity investments. The board should approvepolicies that specify lines of authority andresponsibility for both acquisitions and sales ofinvestments. The board should also approve lim-its on aggregate investment and exposureamounts, the types of investments (for example,direct and indirect, mezzanine financing, start-ups, or seed financing) and appropriatediversification-related aspects of equity invest-ments such as industry, sector, and geographicconcentrations.

For its part, senior management must ensurethat adequate policies, procedures, and manage-ment information systems are in place for man-aging equity investment activities on a day-to-day and longer-term basis. Management shouldset clear lines of authority and responsibility formaking and monitoring investments and formanaging risk. Management should ensure thatcompetent staff conduct the institution’s equityinvestment activities. The staff’s technical knowl-edge and experience should be consistent withthe scope of the institution’s activities.

3909.0.2.2 Management of theInvestment Process

Institutions engaging in equity investmentactivities should have a sound process for

executing all elements of investment manage-ment, including initial due diligence, periodicreviews of holdings, investment valuation, andrealization of returns. This process requiresappropriate policies, procedures, and manage-ment information systems, the formality of whichshould be commensurate with the scope, com-plexity, and nature of an institution’s equityinvestment activities. A sound investment pro-cess should be applied to all equity investmentactivities, regardless of the legal entity in whichinvestments are booked.

Supervisory approach. Any supervisory reviewsof equity investment activities should be risk-focused. The review should take into accountthe institution’s stated tolerance for risk, theability of senior management to govern theseactivities effectively, the materiality of activitiesin light of the institution’s risk profile, and itscapital position.

3909.0.2.2.1 Equity Investment Policiesand Limits

Institutions engaging in equity investmentactivities require effective policies that—

1. govern the types and amounts of investmentsthat may be made,

2. provide guidelines on appropriate holdingperiods for different types of investments,and

3. establish parameters for portfoliodiversification.

Investment strategies and permissible types ofinvestments should be clearly identified.Portfolio-diversification policies should identifyfactors pertinent to the risk profile of the invest-ments being made, such as industry, sector, geo-graphic, and market factors. Policies establish-ing expected holding periods should specify thegeneral criteria for liquidation of investments,as well as guidelines for the divestiture of under-performing investments. Decisions to liquidateunderperforming investments are necessarilymade on a case-by-case basis, considering allrelevant factors. However, policies and proce-dures that stipulate more frequent review andanalysis are generally used to address invest-ments that are performing poorly or that havebeen in portfolio for a considerable length oftime.



Policies should identify the aggregate expo-sure that the institution is willing to accept bythe type and nature of investment (for example,direct or indirect, industry sectors). When adher-ing to those limits, institutions should considerunfunded and funded commitments. Where hedg-ing activities are conducted, formal and clearlyarticulated hedging policies and strategies shouldidentify limits on hedged exposures and permis-sible hedging instruments.

Management and staff compensation play acritical role in providing incentives and control-ling risks within a private equity business line.Clear policies should govern compensation ar-rangements, including co-investment structuresand sales of portfolio company interests byemployees of the BO.

3909.0.2.2.2 Equity InvestmentProcedures

As they do with investment policies, many insti-tutions have different procedures for assessing,approving, and reviewing investments based ontheir size, nature, and risk profile. Often, proce-dures used for direct investments are differentthan those used for indirect investments madethrough private equity funds. For example, dif-ferent levels of due diligence and senior man-agement approvals may be required. The man-agement infrastructures that have beenconstructed for conducting these activities shouldensure that operating procedures and internalcontrols appropriately reflect the diversity ofinvestments.

Supervisory approach. Supervisors should rec-ognize the potential diversity of practice whenconducting reviews of the equity investmentprocess. They should focus on the appropriate-ness of the process employed relative to the riskof the investments made and the materiality ofthis business line to the overall soundness of theBO and the potential impact on affiliated deposi-tory institutions.

3909.0.2.2.2.1 Investment Analysis andApprovals

Well-founded analytical assessments of invest-ment opportunities and formal processes forapproving investments are critical in conductingequity investment activities. While analyses and

approval processes may differ by individualinvestments and across institutions, the methodsand types of analyses conducted should beappropriately structured to adequately assess thespecific risk profile, industry dynamics, manage-ment, and specific terms and conditions of theinvestment opportunity, as well as other relevantfactors. All elements of the analytical andapproval processes, from initial review throughthe formal investment decision, should be docu-mented and clearly understood by the staff whoare conducting these activities. An institution’sevaluation of potential investments in privateequity funds, as well as its reviews of existingfund investments, should assess the adequacy ofa fund’s structure, with due consideration givento the following:

1. management fees2. carried interest6 and its computation on an

aggregate portfolio basis3. the sufficiency of the general partners’ capi-

tal commitments in providing managementincentives

4. contingent liabilities of the general partner5. distributionpoliciesandwind-downprovisions6. performance benchmarks and return-

calculation methodologies

3909.0.2.2.2.2 Investment-Risk Ratings

It is a sound practice to establish a system ofinternal risk-ratings for equity investments. Thesystem should assign each investment a ratingbased on factors such as the nature of the com-pany, strength of management, industry dynam-ics,financial condition,operating results, expectedexit strategies, market conditions, and other per-tinent factors. Different rating factors may beappropriate for indirect investments and directinvestments. For example, rating factors forinvestments in private equity funds could includean assessment of the fund’s diversification, man-agement experience, liquidity, and actual andexpected performance. Rating systems shouldbe used for assessments of both new investmentopportunities and existing portfolio investments.

3909.0.2.2.2.3 Periodic Reviews

Management should ensure the periodic andtimely review of the institution’s equity invest-ments. Reviews should be conducted at both

6. The carried interest is the share of a partnership’s returnthat is received by general partners or investment advisers.



individual investment and portfolio levels.Depending on the size, complexity, and riskprofile of the investment, reviews should, whereappropriate, include factors such as—

1. the history of the investment, including thetotal funds approved;

2. commitment amounts, principal-cash-investmentamounts, costbasis, carryingvalue,major-investment cash flows, and supportinginformation, including valuation rationalesand methodologies;

3. the current actual percentage of ownership inthe portfolio company on both a diluted andundiluted basis;

4. a summary of recent events and current out-look;

5. the recent financial performance of portfoliocompanies, including summary compilationsof performance and forecasts, historical finan-cial results, current and future plans, keyperformance metrics, and other relevant items;

6. internal investment-risk ratings and rating-change triggers;

7. exit strategies, both primary and contingent,and expected internal rates of return on exit;and

8. other pertinent information for assessing theappropriateness, performance, and expectedreturns of investments.

Portfolio reviews should include an aggrega-tion of individual investment-risk and perfor-mance ratings; an analysis of appropriate indus-try, sector, geographic, and other pertinentconcentrations, and total portfolio valuations.Portfolio reports containing the cost basis, carry-ing values, estimated fair values, valuation dis-counts, and other factors summarizing the statusof individual investments are integral tools forconducting effective portfolio reviews. Reportscontaining the results of all reviews should beavailable to supervisors for their inspection.

Given the inherent uncertainties in equityinvestment activities, institutions should includein their periodic review consideration of bestcase, worst case, and probable case assessmentsof investment performance. The reviews shouldevaluate changes in market conditions and alter-native assumptions used to value investments—including expected and contingent exit strate-gies. Major assumptions used in valuinginvestments and forecasting performance shouldbe identified. The assessments need not be con-fined to quantitative analyses of potential losses,but may also include qualitative analyses. Theformality and sophistication of investmentreviews should be appropriate for the overall

level of risk the BO incurs from this businessline.

3909.0.2.2.2.4 Valuation and Accounting

Valuation and accounting policies and proce-dures can have a significant impact on the earn-ings of institutions engaged in equity invest-ment activities. Many equity investments aremade in privately held companies, for whichindependent price quotations are either unavail-able or not available in sufficient volume toprovide meaningful liquidity or a market valua-tion. Valuations of some equity investments mayinvolve a high degree of judgment on the part ofmanagement or require the skillful use of peercomparisons. Similar circumstances may existfor publicly traded securities that are thinlytraded or subject to resale and holding-periodrestrictions, or when the institution holds a sig-nificant block of a company’s shares. Accord-ingly, clearly articulated policies and procedureson the accounting and valuation methodologiesused for equity investments are of paramountimportance.

Several methods are used in accounting forequity investments. Under generally acceptedaccounting principles (GAAP), equity invest-ments held by investment companies, held bybroker-dealers, or maintained in the tradingaccount7 are reported at fair value, with anyunrealized appreciation or depreciation includedin earnings and flowing to tier 1 capital. Forsome holdings, fair value may reflect adjust-ments for liquidity and other factors.

Equity investments not held in investmentcompanies, by broker-dealers, or in the tradingaccount and that have a readily determinablefair value (quoted market price) are generallyreported as available-for-sale (AFS). They aremarked to market with unrealized appreciationor depreciation recognized in GAAP-defined‘‘comprehensive income,’’ but not earnings.Appreciation or depreciation flows to equitybut, for regulatory capital purposes only, depre-ciation is included in tier 1 capital.8 Equityinvestments without readily determinable fair

7. Equity investments in nonfinancial companies held underthe authorities discussed previously would not normally beheld in the trading account, as they are not intended to betraded actively.

8. Under regulatory capital rules, tier 2 capital may includeup to 45 percent of the unrealized appreciation of AFS equityinvestments with readily determinable fair values.



values generally are held at cost, subject towrite-downs due to impairments in the value ofthe asset. As is the case with all assets, impair-ments in value should be promptly addressed.Institutions should ensure that they have takenwrite-downs in a timely manner and in an appro-priate amount.

In determining fair value, the valuation meth-odology is critical. Clearly articulated methodsfor valuing investments are critical to the effec-tive management of equity investments. Formalvaluation and accounting policies should beestablished for investments in public compa-nies; direct private investments; indirect fundinvestments; and, where appropriate, other typesof investments with special characteristics. Inestablishing valuation policies, institutions shouldconsider market conditions, taking account oflockout provisions, the restrictions of Securitiesand Exchange Commission Rule 144, liquid-ity features, the dilutive effects of warrantsand options, and industry characteristics anddynamics.

For institutions acting as general partners ofprivate equity funds, ‘‘clawback,’’ or ‘‘look-back,’’ provisions of partnership agreements canpose additional challenges when accounting forand valuing the distributions received from fundsmanaged by the institution. Clawback provi-sions are promises general partners make torepay limited partners at the end of the term of afund, if the general partner has received morethan its contractually defined compensation or‘‘carried interest’’ over the life of the fund.Clawback provisions can come into play whenthe liquidation and associated disposition ofboth limited-partner and general-partner returnson well-performing investments in a fund occurbefore the liquidation of poorer-performinginvestments. Often, escrow accounts are estab-lished to hold a portion of the general partners’carried interest during the life of the fund. Whenapplicable, institutions should appropriately rec-ognize the estimated impact of these provisionsin accounting for and valuing general-partneractivities, including the earnings derived fromthose activities.

The accounting and valuation of equity invest-ments should be subject to regular periodicreviews. In all cases, valuation reviews shouldproduce documented audit trails that are avail-able to supervisors and auditors. These reviewsshould assess the consistency of the methodolo-gies used to estimate fair value.

Accounting and valuation treatments should

be assessed in light of their potential for abusethrough the inappropriate management ormanipulation of reported earnings on equityinvestments. For example, high valuations mayproduce overstatements of earnings through gainsand losses on investments reported at ‘‘fairvalue.’’ On the other hand, inappropriatelyunderstated valuations can be vehicles for‘‘smoothing earnings’’ by recognizing gains onprofitable investments when an institution’s earn-ings are otherwise under stress. While reason-able people may disagree on the valuationsgiven to illiquid private equity investments,institutions should have rigorous valuation pro-cedures that are applied consistently.

Given the uncertainties in valuation method-ologies and the relatively high volatility of theequitymarket, equity investments that are reportedat fair value can contribute to earnings volatilityin the institutions where they play a major role.Equity investments are increasingly contribut-ing to the earnings of some BOs. Therefore, thepotential impact of these investments on thecomposition, quality, and sustainability of over-all earnings should be appropriately recog-nized and assessed by both management andsupervisors.

3909.0.2.2.2.5 Exit Strategies

Returns and reported earnings on equity invest-ments are highly affected by assumed and actualexit strategies. The principal means of exitingan equity investment in a privately held com-pany include initial public stock offerings, salesto other investors, and share repurchases. Aninstitution’s assumptions regarding exit strate-gies can significantly affect the valuation of theinvestment. The importance of reasonable andcomprehensive primary and contingent take-outstrategies for equity investments should beemphasized. Management should periodicallyreview investment exit strategies, particularlyfocusing on larger or less liquid investments.

3909.0.2.2.2.6 Disposition of Investments

Policies and procedures should be established togovern the sale, exchange, transfer, or otherdisposition of the institution’s investments. Thesepolicies and procedures should state clearly thelevels of management or board approval requiredfor the disposition of investments, and, in thecase of investments held under the merchantbanking provisions of the GLB Act, should take



into account and comply with the time limits forholding merchant banking investments.9

3909.0.2.2.2.7 Capital

Given the potential volatility of returns on equityinvestments, the risks associated with privateequity investment and merchant banking busi-ness lines can exceed those of many more tradi-tional banking activities. BOs that are conduct-ing material equity investment activities shouldhave internal methods for allocating economiccapital based on the risk inherent in those activi-ties.10 These methods should identify all mate-rial risks and their potential impact on the safetyand soundness of the institution. The amountand percentage of capital that is dedicated tothis business line should be appropriate to thesize, complexity, and financial condition of theBO.Organizations substantiallyengaged inequityinvestment and merchant banking activitiesshould have strong capital positions supportingtheir equity investments, and they should allo-cate economic capital to them that is well inexcessof thecurrent regulatoryminimumsappliedto lending activities.

Supervisory approach. Assessments of capitaladequacy (by supervisors and the BO’s manage-ment) should include not only the institution’scompliance with regulatory capital requirementsand the quality of regulatory capital, but also itsmethodologies for internally allocating eco-nomic capital to this business line.

3909.0.2.3 Internal Controls

An adequate system of internal controls, withappropriate checks and balances and clear audittrails, is critical to conducting equity investmentactivities effectively. Appropriate internal con-trols should address all of the elements of theinvestment-management process, and they shouldfocus on the appropriateness of existing policiesand procedures; adherence to policies and pro-cedures; and the integrity and adequacy of invest-ment valuations, risk identification, regulatorycompliance, and management reporting. Depar-tures from policies and procedures should bedocumented and reviewed by senior manage-ment. This documentation should be availablefor examiner review.

Assessments of an institution’s compliancewith both written and implied policies and pro-cedures should be independent of line decision-making functions to the fullest extent possible.Large complex banking institutions with mate-rial equity investment activities should haveinternal auditors or independent outside partiesconduct periodic independent reviews of theirinvestment process and valuation methodolo-gies. In smaller, less complex institutions, wherelimited resources may preclude independentreview, alternative checks and balances shouldbe established. These checks and balances mayinclude random internal audits, reviews by seniormanagement who are independent of the func-tion, or the use of outside third parties.

3909.0.2.3.1 Documentation of theInvestment Process

Documentation of key elements of the invest-ment process, including initial due diligence,approval reviews, valuations, and dispositions,is an integral part of any private equity invest-ment internal-control system. Accordingly,institutions should appropriately document theirpolicies, procedures, and investment activities,and they should make this documentation acces-sible to supervisors.

Institutions should be aware that the statutoryand regulatory authority under which some equityinvestment activities are conducted may imposespecific documentation and recordkeepingrequirements. For example, merchant bankingregulations require an FHC to maintain a writ-ten record any time it becomes involved in theroutine management or operation of a portfoliocompany and to notify the Board if it routinelymanages or operates a portfolio company formore than nine months.

Supervisory approach. Review the documenta-tion of the internal controls over the key ele-ments of the equity investment process. If seniormanagement has authorized and reviewed anydepartures from policies and procedures, reviewthe documentation for those departures.

3909.0.2.3.2 Legal Compliance

Compliance with all federal laws and regula-tions that are applicable to the institution’sinvestment activities should be a focus of an

9. See 12 C.F.R. 225.172.10. The internal methods for allocating economic capital

should be consistent with the general guidance in SR-99-18.



institution’s system of internal controls. Regula-tory compliance requirements, in particular,should be incorporated into internal controls somanagers outside of the compliance or legalfunctions understand the parameters of permis-sible investment activities.

It is important to recognize that private equityand merchant banking activities are subject todifferent laws and regulations, depending on theauthority under which the activities are con-ducted. For example, the merchant bankinginvestments an FHC makes are subject to holding-period limits and restrictions on the FHC’sinvolvement in the routine management oroperation of the portfolio company. Accord-ingly, management should have a system inplace, consistent with applicable laws and regu-lations, to ensure that impermissible control isnot exercised over portfolio companies heldunder this authority and that merchant bankinginvestments are disposed of within the timeperiods required by the rule. Limiting involve-ment in the portfolio company’s day-to-daymanagement and operation is also important toprotect the institution from lender-liability claims.

Likewise, certain cross-marketing restrictionsapply to subsidiary depository institutions ofFHCs and to portfolio companies controlled bytheFHCunder statutorymerchantbankingauthor-ity. Management should ensure that these limitsare observed. When a banking organization ownsor controls a significant percentage of a compa-ny’s voting securities, the company may be anaffiliate of the organization’s depository institu-tion subsidiaries for the purposes of the affiliatetransaction limits of sections 23A and 23B ofthe FRA. Also, the section 23A and 23B limita-tions on transactions between a depository insti-tution and its affiliates are presumed by the GLBAct to apply to certain transactions between adepository institution subsidiary of an FHC andany portfolio company in which the FHC ownsat least a 15 percent equity interest under themerchant banking authority. This ownershipthreshold is lower than the ordinary definition ofan affiliate for section 23A purposes, which istypically 25 percent.

Moreover, to ensure compliance with federalsecurities laws, institutions should establish poli-cies, procedures, and other controls addressinginsider trading. A restricted list of securities forwhich the institution has inside information isone widely used mechanism for controlling therisk of insider trading. In addition, the institu-tion should have control procedures in place to

ensure that appropriate reports are filed withfunctional regulators.

3909.0.2.3.3 Compensation

Often, key employees in the private equity invest-ment units of BOs may co-invest in the direct orfund investments made by the unit. The returnon this co-investment, which the FHC mayunderwrite, may constitute a significant portionof the compensation of these employees. Theseco-investment arrangements can be an impor-tant incentive mechanism and risk-control tech-nique and can help to attract and retain qualifiedmanagement. However, ‘‘cherry picking,’’ orselecting only certain investments for employeeparticipation while excluding others, should bediscouraged.

In many cases, the employees’ co-investmentmay be funded through loans from affiliates ofthe BO, which, in turn, hold a lien against theemployees’ interests. The administration of thecompensation plan should be appropriately gov-erned pursuant to formal agreements, policies,and procedures. Among other matters, policiesand procedures should address the terms andconditions of employee loans and sales of par-ticipants’ interests before the release of the lien.

3909.0.3 DISCLOSURE OF EQUITYINVESTMENT ACTIVITIES

Given the important role that market disciplineplays in controlling risk, institutions shouldensure that they adequately disclose the infor-mation necessary for the markets to assess theinstitution’s risk profiles and performance in theequity investment business line. Indeed, it is inthe institution’s interest, as well as that of itscreditors and shareholders, to disclose publiclyinformation about earnings and risk profiles.Institutions are encouraged to disclose in publicfilings information on the type and nature ofinvestments, portfolio concentrations, returns,and their contributions to reported earnings andcapital. The following topics are relevant forpublic disclosure, though disclosures of each ofthese topics may not be appropriate, relevant, orsufficient in every case:

1. the size of the portfolio2. the types and nature of investments (for

example, direct or indirect, domestic or inter-national, public or private, equity or debtwith conversion rights)



3. the initial cost, carrying value, and fair valueof investments, and, where applicable, com-parisons to publicly quoted share values ofportfolio companies

4. the accounting techniques and valuation meth-odologies, including key assumptions andpractices affecting valuation and changes inthose practices

5. the realized gains (or losses) arising fromsales and unrealized gains (or losses)

6. insights regarding the potential performanceof equity investments under alternative mar-ket conditions

Supervisory approach. Supervisors should fullyuse the disclosures in public filings, as well asthe periodic regulatory reports filed by publiclyheld BOs, as part of the information that theyreview routinely. Supervisors should encourageBOs to make adequate disclosures or to improvetheir public disclosures of equity investment andmerchant banking activities (these disclosuresshould include the items listed above).

3909.0.4 INSTITUTIONS LENDING TOOR ENGAGING IN OTHERTRANSACTIONS WITH PORTFOLIOCOMPANIES

Additional risk-management issues may arisewhen a banking institution or an affiliate lendsto or has other business relationships with (1) acompany in which the banking institution or anaffiliate has invested (that is, a portfolio com-pany); (2) the general partner or manager of aprivate equity fund that has also invested in aportfolio company; or (3) a private-equity-financed company in which the banking institu-tion does not hold a direct or indirect ownershipinterest, but which is an investment or portfoliocompany of a general partner or fund managerwith which the BO has other investments. Giventhe potentially higher than normal risk attributesof these lending relationships, institutions shoulddevote special attention to ensuring that theterms and conditions of these relationships areat arm’s length and are consistent with the lend-ing policies and procedures of the institution.Similar issues may arise in the context of deriva-tives transactions with or guaranteed by port-folio companies and general partners.

Lending and other business transactionsbetween an insured depository institution and aportfolio company that meets the definition ofan affiliate must be negotiated on an arm’s-length basis, in accordance with section 23B ofthe FRA. The holding company also should

have systems and policies in place to monitortransactions between the holding company, or anondepository institution subsidiary of the hold-ing company, and a portfolio company. (Thesetransactions are not typically governed by sec-tion 23B.) A holding company should ensurethat the risks of these transactions, includingexposures of the holding company on a consoli-dated basis to a single portfolio company, arereasonably limited and that all transactions areon reasonable terms. Special attention should bepaid to transactions that are not on market terms.

A BO may lend to a private-equity-financedcompany in which it has no equity interest.When the borrowing company is a portfolioinvestment of private equity fund managers orgeneral partners with which the institution mayhave other private-equity-related relationships,the extension of credit should be conducted onreasonable terms. In some cases, supervisorshave found that lenders may wrongly assumethat the general partners or another third partyimplicitly guarantees or stands behind such cred-its. Reliance on implicit guarantees or comfortletters should not substitute for reliance on asound borrower that is expected to service itsdebt with its own resources. As with any type ofcredit extension, absent a written contractualguarantee, the credit quality of a private equityfund manager, general partner, or other thirdparty should not be used to upgrade the internalcredit-risk rating of the borrower company or toprevent the classification or special mention of aloan. Any tendency to relax this requirementwhen the general partners or sponsors of private-equity-financed companies have significant busi-ness dealings with the BO should be strictlyavoided.

When an institution lends to a portfolio com-pany in which it has a direct or indirect interest,implications arise under sections 23A and 23Bof the FRA, which govern credit-related transac-tions and asset purchases between a depositoryinstitution and its affiliates. Section 23A appliesto transactions between a depository institutionand any company when the institution’s holdingcompany or shareholders own at least 25 per-cent of the company’s voting shares. The GLBAct extends this coverage by establishing a pre-sumption that a portfolio company is an affiliateof a depository institution subsidiary of an FHCif the FHC uses the merchant banking authorityof the GLB Act to own or control more than15 percent of the total equity of the company.Institutions should obtain the assistance of coun-



sel to determine whether such issues exist orwould exist if loans were extended to a portfoliocompany, general partner, or manager.

In addition to limiting and monitoring theexposure to portfolio companies that arises fromtraditional banking transactions, BHCs shouldadopt policies and practices that limit their legalliability, and that of their affiliates, for the finan-cial obligations and liabilities of portfolio com-panies. These policies and practices include, forexample, the use of limited-liability corpora-tions or special-purpose vehicles to hold certaintypes of investments, the insertion of corpora-tions that insulate liability between the BHCand a partnership controlled by the BHC, andcontractual limits on liability. BHCs that extendcredit to companies in which the BHC has madean equity investment should also be aware ofthe potential for equitable subordination of thelending arrangements.

Supervisory approach. Supervisors should ensurethat the institution has conducted a proper reviewof section 23A and 23B compliance issues toavoid violations of law or regulations. Ascertainthat internal controls limit and monitor the expo-sures to portfolio companies in which the insti-tution has a direct or indirect interest. Determineif the BHC has adopted policies and practicesthat limit its legal liability and that of its affili-ates for the financial obligations and liabilitiesof the portfolio companies.

3909.0.5 SUPERVISORY OBJECTIVES

1. To ensure that any risk assessment, supervi-sory strategies, and on-site and targetedreviewsof thebankingorganizationadequatelyand appropriately consider its equity invest-ment and merchant banking activities.

2. To ascertain that the board of directors andsenior management are taking the necessaryactions to ensure that the risks associatedwith private equity investments and mer-chant banking activities are properly identi-fied and managed, and that these activities donot adversely affect the soundness of thebanking organization and its affiliated feder-ally insured depository institutions.

3. To encourage the banking organization’s boardof directors and management to make thenecessary and adequate public disclosures ofits equity investment activities.

4. When the banking organization is engaged in

material equity investmentandmerchantbank-ing activities, to ascertain (1) that the boardof directors and management have taken thenecessary actions to ensure that the organiza-tion has a strong capital position that isadequate to support its activities, and (2) thatthe banking organization has robust internalmethods for allocating capital that fully reflectthe inherent risks of those activities.

5. To assess the existence, adequacy, mainte-nance, and documentation of the institution’ssystem of internal controls over the key ele-ments of the equity investment and merchantbanking process.

6. To review compliance with limits on transac-tions governed by sections 23A and 23B ofthe FRA.

3909.0.6 SUPERVISORYPROCEDURES

1. Identify the organization’s deficiencies andthe material risks that are involved in themanagement of its equity investment andmerchant banking activities. Also identifythose activities that pose potential risks tothe financial condition of state member banksand other federally insured depository insti-tutions affiliated with FHCs and BHCs.Fully use the findings of primary banksupervisors and the functional regulators ofholding company affiliates to review andassess the potential risks of the equity invest-ment activities.

2. Assess the ability of senior management togovern equity investment activities effec-tively, particularly the—a. involvement and oversight by the board

of directors and senior management;b. implementation and maintenance of

appropriate policies, limits, procedures,and management information systems;and

c. system of internal controls.3. Target supervisory efforts to assess the com-

pliance of the board of directors and man-agement with the Federal Reserve’s risk-focused management and supervisionpolicies, considering—a. the BO’s stated tolerance for risk,b. the findings of internal audit and other

independent reviews, andc. the materiality of the activities, consider-

ing the BO’s risk profile.



4. Focus and assess the impact of the equityinvestment activities on insured depositoryaffiliates, considering the potential risks andreturns associated with the activities and thepotential volatility in some segments of theequity markets.

5. Conduct sufficient, targeted transaction test-ing across legal-entity lines, if necessary, tofully assess the adequacy of risk manage-ment in the equity investment business lines.The transaction testing should be consistentwith the institution’s risk profile, the materi-ality of the business line’s activity, and theoverall soundness of the BO’s financialcondition.

6. Assess the adequacy and quality of theBO’s capital position in relation to the riskthat is associated with its equity investmentactivities and the potential impact on affili-ated depository institutions. If the organiza-tion is substantially engaged in equity invest-ment activities, determine that it has a strongcapital position with capital backing that iswell above regulatory minimums for tradi-tional banking activities. Also evaluate theadequacy and quality of the methods usedto internally allocate economic capital tothe business line (or lines) involving equityinvestment activities.

7. Recognize, as a supervisor, that many insti-tutions have diverse practices and proce-dures for assessing, approving, and review-ing investments based on the size, nature,and risk profile of an investment. Focus onand assess the appropriateness, adequacy,and quality of the process employed rela-tive to the—a. risk of the investments made,

b. materiality of this business line in rela-tion to the overall soundness of the BO,and

c. the potential impact on affiliated deposi-tory institutions.

8. Review and determine the adequacy of seniormanagement’s documentation of the inter-nal controls over the key elements of theequity investmentprocess, including itsdocu-mentation for any authorized departuresfrom any of these controls.

9. Use the disclosures the institution has madein public filings and period regulatory reports,and review and assess their adequacy andquality. Encourage the BO to improve anydeficient public disclosures involving equityinvestment and merchant banking activities.

10. Ascertain that—a. the institution maintains and monitors

proper internal controls, and that it con-ducts adequate periodic reviews of thecontrols to ensure its and its affiliate’scompliance with sections 23A and 23Bof the FRA;

b. the internal controls are designed to limitand monitor the institution’s exposure toportfolio companies in which it has adirect or indirect ownership interest; and

c. the BHC has adopted policies and prac-tices that limit its legal liability and thatof its affiliates for the financial obliga-tions of the portfolio companies.

11. Communicate to the management of thebanking organization and other appropriatesupervisors any concerns about deficienciesfound in reviewing equity investment andmerchant banking activities.



Acting as a Finder(Section 4(k) of the BHC Act) Section 3910.0

A finder brings together one or more buyers andsellers of any product or service for transactionsthat the parties themselves negotiate and con-summate. National banks and state banks havebeen permitted to act and have acted as a finderin nonfinancial transactions for many years.Banking organizations have served as a finderby providing enclosures (or ‘‘statement stuffers’’)and other marketing materials from sellers ofvarious products and services. Banking organi-zations have also helped to identify service pro-viders as an accommodation to their customers.Financial holding companies (FHCs) haveargued that acting as a finder, particularly in anelectronic form, offers them increased opportu-nities to cross-sell financial products and ser-vices or to enhance the attractiveness of theirelectronic web site to customers. BHCs andforeign banks that qualify as FHCs may engagein finder activities (as authorized by section225.86(d)(1) of Regulation Y) by providing thepost-transaction notice stipulated in section225.87(a) of Regulation Y.

An FHC may act as a finder for financial andnonfinancial products or services.1 A finderincludes providing any or all of the followingservices:

1. identifying potential parties, making inquir-ies as to their interest, introducing and refer-ring potential parties to each other, andarranging contacts between and meetings ofinterested parties

2. conveying between interested parties expres-sions of interest, bids, offers, orders, andconfirmations relating to a transaction

3. transmitting information concerning prod-ucts and services to potential parties in con-nection with the activities described in thissection

Some examples of finder services that may beprovided by a finder, in accordance with section225.86(d) of the rule, include—

1. hosting an electronic marketplace on theFHC’s Internet web site by providing hyper-text or similar links to the web sites of third-party buyers or sellers;

2. hosting, on the FHC’s servers, the Internetweb site of—• a buyer (or seller) that provides informa-

tion concerning the buyer (or seller) andthe products or services it seeks to buy (orsell) and allows sellers (or buyers) to sub-mit expressions of interest, bids, offers,orders, and confirmations relating to thoseproducts or services; or

• a government or government agency thatprovides information concerning its ser-vices or benefits, assists persons in com-pleting applications to receive such gov-ernment or agency services or benefits, andallows persons to transmit their applica-tions for services or benefits to the govern-ment or agency;

3. operating an Internet web site that allowsmultiple buyers and sellers to (1) exchangeinformation concerning the products and ser-vices that they are willing to purchase or sell,(2) locate potential counterparties for trans-actions, (3) aggregate orders for goods orservices with those made by other parties,and (4) enter into transactions between them-selves; or

4. operating a telephone call center that pro-vides permissible finder services.

An FHC that acts as a finder for a buyer orseller may also provide the buyer or seller withany combination of other services that are per-missible under Regulation Y, so long as thefinder and other services are provided in accor-dance with any applicable limitations under thefinder provisions of Regulation Y. For example,a finder for a merchant may, in addition toacting as a finder, make, acquire, broker, orservice loans or other extensions of credit to orfor the merchant or merchant’s customers; pro-vide the merchant with check-verification, check-guaranty, collection agency, and credit bureauservices; provide financial investment advice tothe merchant or its customers (within the param-eters of Regulation Y); act as a certificationauthority for digital signatures and therebyauthenticate the identity of persons conductingbusiness with the merchant over electronic net-works; and process and transmit financial, eco-nomic, and banking data on behalf of the mer-chant, such as processing the merchant’s accountsreceivable and debit and credit card transac-tions. The FHC may also provide the merchant

1. An FHC is permitted to act as a finder for financialproducts and services as part of other permissible financialactivities. For example, an FHC may act as a finder (1) in thepurchase and sale of securities under authority to act as asecurities broker under section 225.86(a) of Regulation Y or(2) in the purchase or sale of insurance products as an insur-ance agent under section 225.86(c) of Regulation Y.


with bill-payment and billing services, as wellas processing order, distribution, accounting,settlement, collection, and payment informationfor the merchant’s transactions.

Furthermore, an FHC may market and pro-vide its own financial products and services inconjunction with acting as a finder for buyersand sellers of nonfinancial products and ser-vices. For example, an FHC may use its finderservices to promote a company’s products andservices and, in connection with that activity,may negotiate on its own behalf and bind itselfto transactions.

3910.0.1 LIMITATIONS ON AN FHCTHAT ACTS AS A FINDER

A finder cannot serve as a principal in the under-lying transaction. A finder may act only as anintermediary between a buyer and a seller. Afinder may not negotiate for or bind any buyeror seller to the terms of a specific transaction ornegotiate the terms of a specific transaction onbehalf of a buyer or seller. However, a findermay—

1. arrange for buyers to receive preferred termsfrom sellers so long as the terms are notnegotiated as part of any individual transac-tion, are provided generally to customers orbroad categories of customers, and are madeavailable by the seller (and not by the FHC),and

2. establish rules of general applicability gov-erning the use and operation of the finderservice, including rules that—• govern the submission of bids and offers

by buyers and sellers that use the finderservice and the circumstances under whichthe finder service will match bids and offerssubmitted by buyers and sellers, and

• govern the manner in which buyers andsellers may bind themselves to the terms ofa specific transaction.

A finder may not (1) take title to or acquire orhold an ownership interest in any product orservice offered or sold through the finder ser-vice; (2) provide distribution services for physi-cal products or services offered or sold throughthe finder service; (3) own or operate any realor personal property that is used for the pur-pose of manufacturing, storing, transporting, orassembling physical products offered or sold bythird parties; or (4) own or operate any real orpersonal property that serves as a physical loca-tion for the physical purchase, sale, or distribu-tion of products or services offered or sold bythird parties. Further, a finder cannot engage inany activity that would require the company toregister or obtain a license as a real estate agentor broker under applicable law.

3910.0.2 REQUIRED DISCLOSURES

A finder is required to distinguish the productsand services offered by the FHC from thoseoffered by a third party through the finder ser-vice. Because an FHC may act as a finder forthird parties through varied technological meansand in a wide variety of circumstances, FHCsare not required to provide specific disclosures.The Board expects FHCs to provide disclosuresthat, given the medium employed and type ofbuyers and sellers using the service (for example,consumers or corporations), are reasonablydesigned to ensure that users are not led tobelieve that the FHC is providing the productsor services offered or sold by third parties throughthe finder service. An FHC could provide suchnotice by identifying those products or servicesthat are offered or sold by the FHC (with acorresponding notice that all other products orservices are provided by third parties), or byidentifying those products or services that areoffered and sold by third parties and not by theFHC.

Acting as a Finder 3910.0


To Acquire, Manage, and Operate Defined Benefit Pension Plansin the United Kingdom (Section 4(k) of the BHC Act) Section 3912.0

A financial holding company (FHC), a bankholding company (BHC) that meets the require-ments of 4(l)(1) of the Bank Holding CompanyAct (the BHC Act),1 proposed to acquire, man-age, and operate in the United Kingdom definedbenefit pension plans established and main-tained by unaffiliated third parties (third-partyUK pension plans). The activities would beconducted by or through a nonbank subsidiaryof the FHC. The FHC would acquire third-partyUK pension plans in standalone transactions andnot as part of the acquisition of all or part of theongoing business operations of the third parties.

Section 4 of the BHC Act generally prohibitsa BHC, including an FHC, from directly orindirectly engaging in, or acquiring the shares ofa company engaged in, any nonbanking activityunless the activity is otherwise permissible underthe act. Section 4(k) of the BHC Act, as amendedby the Gramm-Leach-Bliley Act (the GLB Act),permits a BHC that qualifies to be an FHC toengage in, and acquire and retain shares of anycompany engaged in, a broad range of activitiesthat are defined by statute to be financial innature.2 The BHC Act also permits an FHC toengage in, and acquire and retain shares of anycompany engaged in, any activity that the Boarddetermines, by order or regulation and in consul-tation with the Secretary of the Treasury, to befinancial in nature or incidental to a financialactivity.3

A defined benefit pension plan generally is aplan established by or on behalf of an employer(the plan ‘‘sponsor’’). The plan provides for thepayment of benefits to employees, typicallybeginning on their retirement or other termina-tion of service, in an amount that is specified inanddeterminableunder theplan, typically througha formula that takes into account the employee’spay, years of employment, age at retirement,and other factors.4 The terms of the plan itselfalso typically specify (1) the circumstances underwhich benefits will be paid under the plan to an

employee, a former employee, or a related per-son (such as a spouse) (collectively, a benefi-ciary) and (2) the length of time such paymentswill be made to a beneficiary. The benefits pay-able under a plan typically take the form of aspecified stream of payments that begin onretirement or, at the employee’s option, a lumpsum payable at retirement; plan rules may alsoprovide for other ancillary benefits, such asspousal or survivor benefits.5 The nonbank sub-sidiary of the FHC that directly acquires a third-party UK pension plan would assume theresponsibilities of the plan’s sponsor underapplicable UK law. In the United Kingdom,defined benefit pension plans are regulated bythe UK Pensions Regulator under the PensionsAct of 1995, the Pensions Act of 2004, and thegeneral law of trusts. These laws provide thatpension plans must be managed and adminis-tered by a trustee that is independent of the plansponsor. Plan sponsors must also provide suffi-cient assets to a pension plan to pay all benefitsunder the plan,6 consult with the trustees for thepension plan concerning the investment strategyof the plan, and agree with the plan trustees on astatement of funding principles that sets out theplan’s funding target, methods, and assump-tions. In addition, trustees and plan sponsorsmust agree on amendments to any part of theplan.

As proposed, the FHC would acquire a third-party UK pension plan only if no additionalbeneficiaries may be added to the plan andexisting beneficiaries may not accrue additionalbenefits under the plan (a hard-frozen plan). Inaddition, the FHC would acquire a third-partyUK pension plan only if the plan, at the time ofits acquisition, is fully funded by the sellingsponsor, based on the plan’s assets and pro-jected liabilities (using appropriate actuarialassumptions).7 The FHC indicated that, as partof its due-diligence process for each transaction,

1. 12 U.S.C. 1841 et seq.2. See 12 U.S.C.1843(k)(4).3. 12 U.S.C. 1843(k)(1)(A) and (2). In addition, the BHC

Act permits an FHC to engage in any activity that the Board(in its sole discretion) determines, by regulation or order, is‘‘complementary to a financial activity and does not pose asubstantial risk to the safety or soundness of depository insti-tutions or the financial system generally’’ (12 U.S.C.1843(k)(1)(B)).

4. A defined contribution plan is a benefit plan underwhich an individual account is established for each participantand the benefits payable to each participant are based on theamount contributed to the participant’s account, plus or minusincome, gains, expenses, and losses allocated to that account.

5. ‘‘Defined benefit pension plan’’ does not include a planthat provides health insurance to employees or that guaranteesor indemnifies employees for health care costs.

6. The sponsor may recover assets contributed to or heldon behalf of a plan after all of the plan’s obligations tobeneficiaries have been satisfied and the plan is closed out.

7. The term ‘‘fully funded’’ means that, at the time ofacquisition, the current value of the plan’s assets is at leastequal to the present value of the plan’s projected liabilities.The selling sponsor may issue debt to the plan or the FHC tofully fund the plan at acquisition. In some situations, therequirement that a plan be fully funded may require funding


it would employ qualified actuaries to reviewand analyze the present value of benefits owedto plan beneficiaries to ensure that all pensionplans acquired are fully funded by the sellingsponsor.

The activity of acquiring, operating, and man-aging third-party pension plans had not beenpreviously determined to be financial in natureor incidental to a financial activity for purposesof the BHC Act. The activity proposed is broaderthan the pension plan activities that FHCs arecurrently permitted to conduct for third parties.For example, as discussed above, a nonbanksubsidiary of the FHC would assume the rightsand obligations of the sponsor of an acquiredthird-party UK pension plan and would do so intransactions that do not represent the acquisitionof a going concern or ongoing business opera-tions by the FHC. In addition, the assets andliabilities of an acquired third-party UK pensionplan (unlike assets held by an FHC as trustee forthird parties or assets held by the pension plansmaintained for the FHC’s own employees) wouldbe fully consolidated with the assets and liabili-ties of the FHC on its balance sheet.8

The Board concluded, for the reasons setforth below, that there is a reasonable basis fordetermining that the acquisition, management,and operation by the FHC of hard-frozen, fullyfunded third-party UK pension plans is an activ-ity that is financial in nature within the meaningof the BHC Act. The activity involves, at itscore, the types of investment advisory andinvestment management skills that are routinelyexercised by banking organizations and alsoinvolves the types of operational and investmentrisks that banking organizations routinely incurand manage.

FHCs are currently permitted by the BHCAct to engage in activities that are related oroperationally and functionally similar to the pro-posed activity and that involve similar risks. Forexample, an FHC is already permitted to pro-

vide a wide variety of services to third-partypension plans, including acting as trustee, custo-dian, or investment adviser (with or withoutinvestment discretion) for a third-party benefitplan, as well as designing, assisting in the imple-mentation of, providing administrative servicesto, and developing employee communicationprograms for third-party benefit plans.9 FHCsengaged in these activities have gained substan-tial expertise with the laws, regulations, andfiduciary obligations associated with providingfiduciary, custodial, and administrative servicesto pension plans. Moreover, FHCs engaged inthese plan-related activities have developed risk-management systems and internal controls tomonitor, manage, and address the legal, opera-tional, and reputational risks associated withmanaging the investments of and administeringthird-party pension plans.

The proposed activity also bore a strong func-tional resemblance to the issuance of a groupannuity contract. The BHC Act, as amended bythe GLB Act, expressly states that providingand issuing annuities is an activity that is finan-cial in nature.10 A company that issues a fixedannuity becomes obligated to make periodicpayments to the annuitant during his or herlifetime and to pay any death or survivor ben-efits in accordance with the terms of the annuitycontract. The company that issues a fixed annu-ity assumes responsibility for investing and man-aging the funds received from the annuitant andbears the risk that such funds and the returnsearned on the funds will not be sufficient to payout the full amount of benefits promised underthe annuity contract. The company also assumesresponsibility for administering the annuity con-tract both before and during its payout period.

In connection with these activities, the issuerof fixed annuities is exposed to certain types ofrisks, which are part of the activity determinedto be financial in the GLB Act. These risksinclude the risk that (1) the life expectancy ofannuitants, on average, will exceed the actuarialestimates used in establishing the terms of andfunding for the annuities; (2) the inflation rateand other assumptions used to determine theexpected obligations under the annuity contractsunderestimate these obligations; and (3) pay-ments from the annuitant and the return obtainedthrough the investment of such payments willfall short of estimates.

The FHC would perform essentially the samefinancial functions and assume essentially thesame financial obligations and risks through the

in excess of the statutory funding requirements of the relevantjurisdiction.

8. Since the FHC would acquire each third-party UK pen-sion plan in a standalone transaction, and not as part of abusiness combination involving it and the selling sponsor, theFHC stated that it will fully reflect the assets and liabilities ofan acquired plan as assets and liabilities of the FHC on itsbalance sheet. This treatment differs from the manner inwhich the assets and liabilities of an internal pension plan ofan employer typically are accounted for on the balance sheetof the employer under U.S. generally accepted accountingprinciples. See Statement of Financial Accounting StandardsNo. 158 (FAS 158), ‘‘Accounting for Defined Benefit Pensionand Other Post Retirement Plans.’’

9. See 12 C.F.R. 225.28(b)(5), (6), and (9)(ii).10. 12 See 12 U.S.C. 1843(k)(4)(B).

To Acquire, Manage, and Operate Defined Benefit Pension Plans in the United Kingdom 3912.0


acquisition of a third-party UK pension plan asan insurance company would perform and assumein connection with the issuance of fixed annu-ities. The functional similarity between a plansponsor’s obligations under a defined benefitpension plan and an insurance company’s obli-gations under an annuity contract is especiallyclose when the pension plan is both fully fundedand hard-frozen, as it is in the FHC’s proposedactivity. When a pension plan’s obligations toplan beneficiaries are hard-frozen and the planis fully funded, one method commonly used bya plan sponsor to close out a plan is to purchasea terminal funding group annuity contract froman insurance company. Through such an annuitycontract, the provider of the annuity becomesobligated to satisfy the responsibility to pay thebenefits promised under the plan to the plan’sbeneficiaries. The FHC’s proposed activitieswould be specifically permitted under the BHCAct if they were provided through an annuitycontract or other form of insurance.

When evaluating this proposal, the Boardconsidered that, under UK law, the nonbanksubsidiary established by the FHC to acquire athird-party UK pension plan will generally bearsole responsibility for making additional contri-butions to the plan if the plan assets are notsufficient to meet the plan’s expected or actualliabilities. However, UK law also permits theUK Pensions Regulator in certain circumstancesto commence proceedings to hold an affiliate ofa plan sponsor (including a depository institu-tion affiliate) responsible for the sponsor’s obli-gations to the plan.11

Generally, the Board has taken the positionthat, when a depository institution is secondarilyliable for a financial obligation of an affiliate,even if the depository institution’s liability iscreated by statute or regulatory action, the insti-tution has issued a guarantee on behalf of anaffiliate for purposes of section 23A of the Fed-eral Reserve Act and the Board’s Regulation W.Section 23A and Regulation W impose quantita-tive and qualitative limits on covered transac-tions between a depository institution and itsaffiliates.12 The limitations in section 23A andRegulation W provide important protectionsagainst a depository institution suffering lossesdue to covered transactions with its affiliates

and also limit the ability of a depository institu-tion to transfer to its affiliates the subsidy aris-ing from the institution’s access to the federalsafety net.

To address the potential section 23A andRegulation W issues presented by its initial pro-posed transaction, and in accordance with UKlaw,13 the FHC obtained written assurances fromthe UK Pensions Regulator that it will not seekto hold any of the FHC’s depository institutionsubsidiaries that are subject to section 23Aresponsible for any shortfalls that may occur inthe pension plan proposed to be acquired by theFHC in this initial transaction. As a condition ofthis order, the FHC must obtain similar writtenassurances from the UK Pensions Regulatorbefore acquiring any additional third-party UKpension plan.14

Based on the foregoing and other facts ofrecord, the Board concluded that the acquisition,management, and operation by the FHC of hard-frozen, fully funded third-party UK pensionplans, when conducted in accordance with theconditions and limitations set forth in the order,is an activity that is financial in nature withinthe meaning of section 4(k) of the BHC Act.Any investment made by a third-party UK pen-sion plan acquired by the FHC must otherwisebe permissible for an FHC under the BHC Actand the Board’s Regulation Y.15 The authoriza-tion and determination granted by the Board’sorder is limited to the acquisition, management,

11. See the UK Pensions Act of 2004, section 38 (contribu-tion notices) and section 43 (financial support directives). TheUK Pensions Regulator may issue a contribution notice orfinancial support directive to an affiliate of a sponsor only if,among other things, the Pensions Regulator determines that itis reasonable to impose the proposed financial obligations onthe affiliate.

12. See 12 U.S.C. 371c(b)(7) and 12 C.F.R. 223.3(h).

13. The Pensions Act of 2004 expressly authorizes the UKPensions Regulator, on application by a plan or other person,to issue a ‘‘clearance statement’’ that determines that it wouldbe unreasonable to issue a contribution notice or financialsupport directive to the plan or person under the circum-stances described in the application. See Pensions Act of2004, sections 42 and 46. The FHC received such a clearancestatement with respect to its initial proposed acquisition of athird-party pension plan in the United Kingdom.

14. The FHC has indicated that the written assurancesprovided by the UK Pensions Regulator are subject to reviewand renewal by the regulator no later than five years afterissuance. Before the expiration of any written assurancesprovided by the UK Pensions Regulator in connection withthe acquisition by the FHC of a third-party UK pension plan,the FHC must either ensure that its activities conform withthose permitted under section 23A and Regulation W orobtain an exemption from the Board from the limitations ofsection 23A and Regulation W with respect to the plan. TheBoard has not determined that section 23A applies to thecontingent liabilities that may arise under applicable pensionlaw from the establishment or operation by an affiliate of adepository institution of employee benefit plans in the ordi-nary course of its other business to provide benefits to theemployees or former employees of the affiliate.

15. See, for example, 12 U.S.C. 1843(c)(5), (c)(6), and(k)(4)(H).



and operation by the FHC of third-party pensionplans in the United Kingdom.16

Under the BHC Act, the Board may not deter-mine, by regulation or order, that an activity isfinancial in nature or incidental to a financialactivity if the Secretary of the Treasury (theSecretary) notifies the Board in writing that theSecretary believes the activity is not financial innature, incidental to a financial activity, or other-wise permissible under section 4 of the BHCAct.17 The Board provided the Secretary of theTreasury with notice of the FHC’s proposal inaccordance with the BHC Act, and the Secretaryinformed the Board in writing that the Secretary

did not intend to prevent the Board from autho-rizing the FHC to engage in the proposed UKpension activities, subject to the conditions andlimitations in the Board’s order.

The Board’s determination and approval issubject to all the conditions set forth in Regula-tion Y, including those in section 225.7,18 and tothe Board’s authority to require modification ortermination of the activities of a bank holdingcompany or any of its subsidiaries as the Boardfinds necessary to ensure compliance with, or toprevent evasion of, the provisions and purposesof the BHC Act and the Board’s regulations andorders. The Board’s decision is specifically con-ditioned on compliance with all the commit-ments made to the Board in connection with therequest, including the commitments and condi-tions discussed in the order. The Board’s orderwas approved and effective on October 12,2007.18

16. Other FHCs may seek approval to engage in similaractivities by requesting a determination with respect to theirown proposed activities under section 4(k)(2)(A) of the BHCAct and section 225.88 of the Board’s Regulation Y (12C.F.R. 225.88).

17. See 12 U.S.C. 1843(k)(2)(A). 18. 12 C.F.R. 225.7.



Limited Physical-Commodity-Trading Activities(Section 4(k) of the BHC Act) Section 3920.0


Effective July 2008, a brief discussion of a

Board order in which the Board considered

under section 4(k) of the Bank Holding Com-

pany (BHC) Act, and approved, a financial hold-

ing company (FHC)’s limited trading in certain

physical commodities that are not approved by

the Commodities Futures and Trading Commis-

sion (CFTC) for trading in the U.S. or on non-

U.S. futures exchanges. To trade in such com-

modities, the FHC must be able to demonstrate

that the derivative contracts on the commodity

satisfy the specified standards that are stated in

the order. The section also discusses the Board’s

approval of the same FHC’s request to make

and take delivery in nickel, a metal that is

traded on the London Metal Exchange (LME)—a

CFTC-comparable regulatory entity. Members

of the LME can conduct brokerage activities for

U.S. customers without being registered with the

FTC as a futures commission merchant.

An FHC’s Board-approved request to permit

the refining, blending, or altering of approved

commodities by a third party is reviewed within

the section along with the use of recognized

alternate trading platforms. The same Board

order includes the Board’s approval of the FHC’s

request to engage in limited physically settled

energy tolling by entering into tolling agree-

ments with power plant owners. The Board

determined that the activity is complementary to

the financial activity of engaging as principal in

commodity derivatives transactions. The FHC

nonbank activity had not been previously

approved by the Board. (See 2008 FRB C60.)

For another Board order, the section dis-

cusses the Board’s approval of an FHC’s request

to engage in providing Energy Management Ser-

vices (EMS) to owners of power generation

facilities. The EMS are to be provided under

energy management agreements as a comple-

ment to the financial activities of engaging as

principal in commodity derivatives and provid-

ing financial and investment advisory services

for derivative transactions. (See 2008 FRB

C20.)

3920.0.1 ENGAGING IN LIMITED FHCCOMMODITY-TRADING ACTIVITIESINVOLVING A PARTICULARCOMMODITY AS A COMPLEMENTTO THE BHC-PERMISSIBLEFINANCIAL ACTIVITY OFENGAGING REGULARLY INCOMMODITY DERIVATIVES BASEDON THAT COMMODITY

An FHC requested the Board’s approval undersection 4(k) of the Bank Holding Company Act(the BHC Act) to retain all of the shares of acompany that engaged in a variety of commodity-related activities in the United States, includingtrading in physical commodities, an activity notpreviously approved under the BHC Act.

Regulation Y authorizes bank holding com-panies (BHCs) to engage as principal in forwardcontracts, options, futures, options on futures,swaps, and similar contracts, whether traded onexchanges or not, based on a rate, price, finan-cial asset, nonfinancial asset, or group of assets(other than a bank-ineligible security) (com-modity derivatives). A BHC may conductcommodity-derivatives activities under Regula-tion Y subject to certain restrictions that aredesigned to limit the BHC’s activity to tradingand investing in financial instruments ratherthan dealing directly in physical nonfinancialcommodities. Under these restrictions, a BHCmay take and make delivery of physicallysettled derivatives involving commodities that astate member bank is permitted to own.1 For allother types of physically settled derivatives,2 aBHC must make reasonable efforts to avoiddelivery on such derivatives or must take andmake delivery only on an instantaneous, pass-through basis. (See section 3260.0.4.6.) Otherthan in the limited circumstances describedabove in connection with commodity deriva-tives, Regulation Y generally does not permitBHCs to take or make delivery of nonfinancialcommodities underlying commodity derivaties.In addition, BHCs are generally not permitted topurchase or sell nonfinancial commodities in thespot market.

1. State member banks may own, for example, investment-grade corporate debt securities, U.S. government and munici-pal securities, foreign exchange, and certain precious metals.

2. These derivative contracts would include instrumentsbased on, for example, energy-related and agriculturalcommodities.


The FHC requested that the Board expand theauthority of FHCs to purchase and sell com-modities in the spot market and to take andmake delivery of physical commodities to settlecommodity derivatives (commodity-tradingactivities), by determining that these activitiesare ‘‘incidental’’ to a financial activity (pursuantto section 4(k) of the BHC Act). Commodity-trading activities typically involve the commer-cial activities of physically owning and dispos-ing of assets such as oil, natural gas, agriculturalproducts, and other nonfinancial commodities.Moreover, the risks associated with conductingthese activities are commercial risks not tradi-tionally incurred or managed to a material extentby banking organizations. Accordingly, the Boarddid not believe that commodity-trading activi-ties could be construed as incidental to a finan-cial activity within the meaning of the Gramm-Leach-Bliley Act (the GLB Act) or the BHCAct. The Board concluded, however, for thereasons set forth below, that there was a reason-able basis for construing these activities ascomplementary to a financial activity within themeaning of the GLB Act or the BHC Act.

Section 4(k)(1)(B) of the BHC Act permitsFHCs to seek Board approval to engage in anyactivity the Board determines (1) to be comple-mentary to a financial activity and (2) not topose a substantial risk to the safety and sound-ness of depository institutions or the financialsystem generally. FHCs must submit a writtenrequest for the Board’s approval to engage in acomplementary activity through the filing of anotice under section 4 of the BHC Act. TheBoard considers each request on a case-by-casebasis. (Subsection 3905.0.1 provides a list of theinformation that needs to be included with sucha request.)

A number of considerations supported a Boarddetermination that commodity trading activitiesare complementary to a financial activity. (See2003 FRB 508.) Commodity-trading activitiescan flow from the existing financial activities ofFHCs. In particular, commodity-trading activi-ties provide FHCs with an alternative method offulfilling their obligations under otherwise BHC-permissible commodity derivatives. For exam-ple, if warranted by market conditions, an FHCwould be able to use commodity-trading-activityauthority to take a commodity derivative tophysical settlement rather than terminating,assigning, offsetting, or otherwise cash-settlingthe contract.

The Board also noted that the applicant con-

tended that the existing restrictions of Regula-tion Y place FHCs at a significant bargainingdisadvantage when operating in physically settledover-the-counter (OTC) derivatives markets.According to the applicant, counterparties toFHCs in these markets are aware of the regula-tory impediments that inhibit BHCs and FHCsfrom taking derivative contracts to physicalsettlement. As a consequence, BHCs and FHCsthat participate in these markets can be forced toterminate or offset their derivative contracts onuneconomic terms. Allowing BHCs and FHCsto engage in commodity-trading activities wouldpermit FHCs to compete in physically settledOTC derivatives markets more economically.

The Board concluded that commodity tradingactivities involving a particular commoditycomplement the financial activity of engagingregularly as principal in BHC-permissible com-modity derivatives based on that commodity.3 Inorder to authorize FHCs to engage in commodity-trading activities as a complementary activityunder the GLB Act, the Board must also deter-mine that those activities do not pose a substan-tial risk to the safety or soundness of depositoryinstitutions or the U.S. financial system gener-ally.4 To limit the potential safety-and-soundness risks of commodity-trading activi-ties, the applicant proposed to engage in only alimited amount of commodity-trading activities.As a condition of the Board’s order, the marketvalue of commodities held by the applicant as aresult of commodity-trading activities must notexceed 5 percent of the applicant’s consolidatedtier 1 capital.5 The applicant also must notify itsdesignated supervising Federal Reserve Bank ifthe market value of commodities held by theapplicant as a result of its commodity-tradingactivities exceeds 4 percent of its tier 1 capital.

In addition, the Board’s order permitted theapplicant to take and make delivery of onlyphysical commodities for which derivative con-tracts have been approved for trading on a U.S.futures exchange by the Commodity FuturesTrading Commission (CFTC) (unless specifi-cally excluded by the Board) or that have beenspecifically approved by the Board.6 This

3. For example, commodity-trading activities involving alltypes of crude oil would be complementary to engagingregularly as principal in BHC-permissible commodity deriva-tives based on Brent crude oil.

4. 12 U.S.C. 1843(k)(1)(B).5. The applicant is required to include in this 5 percent

limit the market value of any commodities it holds as a resultof a failure of its reasonable efforts to avoid taking deliveryunder section 225.28(b)(8)(ii)(B) of Regulation Y.

6. The particular commodity-derivative contract that theapplicant takes to physical settlement need not be exchange-traded, but (in the absence of specific Board approval) futures

Limited Physical-Commodity-Trading Activities 3920.0


requirement is designed to prevent the applicantfrom becoming involved in dealing in finishedgoods and other items, such as real estate, thatlack the fungibility and liquidity of exchange-traded commodities.

The Board concluded that permitting the appli-cant to buy and sell commodities in the spotmarket or physically settle commodity deriva-tives would not appear to increase significantlythe organization’s potential exposure tocommodity-price risk.

The Board’s order acknowledged that add-ing commodity-trading activities would exposethe applicant to additional risks, including, butnot limited to, storage risk, transportation risk,and legal and environmental risks. To minimizethese risks, the applicant was not authorized to(1) own, operate, or invest in facilities for theextraction, transportation, storage, or distribu-tion of commodities or (2) process, refine, orotherwise alter commodities. In conducting itscommodity-trading activities, the applicant wasexpected to use appropriate storage andtransportation facilities owned and operated bythird parties.7

The applicant indicated that it will mandatethat the commodity-storage facilities it uses haveall required governmental permits and providethe applicant with a certificate to that effect. Theapplicant further stated that all commodity-storage facilities will be inspected by or on itsbehalf before use and that it will physicallyinspect any commodity in storage every sixmonths.

The applicant also stated that it would adoptadditional standards for commodity-tradingactivities that involve environmentally sensitiveproducts, such as oil or natural gas. For exam-ple, the applicant will require that the owner ofevery vessel that carries oil on its behalf be amember of a protection and indemnity club andcarry the maximum insurance for oil pollutionavailable from the club. Every such vessel will

be required to carry substantial amounts of addi-tional oil-pollution insurance from creditworthyinsurance companies. The applicant will placeage limitations on vessels and will require ves-sels to be approved by a major international oilcompany and have appropriate response plansand equipment for oil spills. The applicant willalso have a comprehensive backup plan in theevent any vessel owner fails to respond adequatelyto an oil spill and will hire inspectors to monitorthe loading and discharging of vessels.

The applicant also represented that it will havein place specific policies and procedures for thestorage of oil. In addition, the applicant willrequire all oil-storage facilities it uses to carry asignificant amount of oil-pollution insurancefrom a creditworthy insurance company and tohave appropriate spill-response plans andequipment. The applicant will also follow acomprehensive backup plan in the event thestorage facility owner fails to respond adequatelyto an oil spill.

The Board determined that the applicant hadthe managerial expertise and internal controlframework to manage the risks of taking andmaking delivery of physical commodities. Italso concluded that the applicant had theexpertise and internal controls to integrateeffectively the risk management of commodity-trading activities into its overall risk-management framework, which includesmanaging on a consolidated basis the overallexposure arising from the applicant’scommodity-related activities.

For these reasons, and based on the appli-cant’s policies and procedures for monitoringand controlling the risks of commodity-tradingactivities, the Board concluded that consumma-tion of the proposal did not pose a substantialrisk to the safety and soundness of depositoryinstitutions or the financial system generally andcould reasonably be expected to produce bene-fits to the public that outweighed any potentialadverse effects. (See 2003 FRB 508.)

In another Board order (2004 FRB 215), aforeign bank (the FB) that is treated as a finan-cial holding company (FHC) for purposes of theBank Holding Company Act (the BHC Act),requested the Board’s approval under section 4of the BHC Act (12 U.S.C. 1843) and theBoard’s Regulation Y (12 C.F.R. 225) to retainall the voting shares of FB Energy, LLC, locatedin Connecticut (FB Energy) and to continueengaging in physical-commodity trading in theUnited States. The FB conducts physical-

or options on futures on the commodity underlying the deriva-tive contract must have been approved for exchange tradingby the CFTC. The CFTC publishes annually a list of theCFTC-approved commodity contracts. See, for example, Com-modity Futures Trading Commission, FY 2002 Annual Report

to Congress 124 and FY 2003 Annual Report to Congress 109.With respect to granularity, the Board intends this require-

ment to permit commodity-trading activities involving alltypes of a listed commodity. For example, commodity-tradingactivities involving any type of coal or coal-derivative con-tract would be permitted, even though the CFTC list specifi-cally approves only Central Appalachian coal.

7. The Board’s approval of commodity-trading activitiesas a complementary activity, subject to the limits and condi-tions, did not restrict the existing authority of the applicant todeal in foreign exchange, precious metals, or any other bank-eligible commodity.



commodity trading in the United States pursu-ant to temporary grandfather authority providedby the BHC Act and Regulation Y.8

The FB requested that the Board permit it topurchase and sell physical commodities in thespot market and to take and make delivery ofphysical commodities to settle commodityderivatives (commodity-trading activities). Asnoted in the 2003 Board order (2003 FRB 508),the Board had previously determined thatcommodity-trading activities involving a par-ticular commodity complement the financialactivity of engaging regularly as principal inBHC-permissible commodity derivatives basedon that commodity. The FB regularly engages asprincipal in BHC-permissible commoditiesderivatives based on a variety of commodities,including natural gas and electricity. The Boarddetermined that the commodity-trading activi-ties are complementary to the commodity-derivatives activities of the FB.

The FB has established and maintained poli-cies for monitoring, measuring, and controllingthe credit, market, settlement, reputational, legal,and operational risks involved in its commodity-trading activities. These policies address keyareas such as counterparty credit risk, value-at-risk methodology and internal limits with respectto commodity trading, new-business and new-product approvals, and identification of transac-tions that require higher levels of internalapproval. The policies also describe criticalinternal control elements, such as reporting lines,and the frequency and scope of internal audit ofcommodity-trading activities.

The FB is subject to the same commitmentsand restrictions set forth in the previously dis-cussed Board order (2003 FRB 508). The FBand its commodity-trading activities also remainsubject to the general securities, commodities,and energy laws and to the rules and regulations(including the anti-fraud and anti-manipulationrules and regulations) of the Securities andExchange Commission, the CFTC, and the Fed-eral Energy Regulatory Commission.

The Board concluded that permitting the FB toengage in the limited amount and types ofcommodity-trading activities described previ-ously, on the terms described in the order, wouldnot appear to pose a substantial risk to the FB,depository institutions, or the U.S. financial

system generally. Because of its existingauthority to engage in commodity derivatives,the FB could already incur the price riskassociated with commodities. Therefore, permit-ting the FB to buy and sell commodities in thespot market or to physically settle commodityderivatives did not appear to increase signifi-cantly the organization’s potential exposure tocommodity-price risk.

Based on the reasons stated in the Board’sorder, and based on the FB’s policies and proce-dures for monitoring and controlling the risks ofcommodity-trading activities, the Board con-cluded that consummation of the proposal didnot pose a substantial risk to the safety andsoundness of depository institutions or the finan-cial system generally and that it could reason-ably be expected to produce benefits to thepublic that outweigh any potential adverse effects.

Based on all the facts of record, including therepresentations and commitments made by theFB in connection with the notice, and subject tothe terms and conditions set forth in the order,the Board approved the notice on January 27,2004. (See 2004 FRB 215 and the notice approvedby the Board at 2004 FRB 511; both FHCs wereapproved by the Board to engage in limitedphysical-commodity trading involving such com-modities as natural gas and electricity.) Also seethe approvals for FHCs to engage in limitedcommodities trading that included certain energy-related commodities, such as natural gas, crudeoil, electricity, and emissions allowances.9 TheseBoard orders were approved on November 18,2005 (2006 FRB C57), December 19, 2005(2006 FRB C54), and March 15, 2006 (2006FRB C113). Subsequently, the Board delegatedits authority to approve notices by FHCs toengage in physical-commodity trading as acomplementary activity to the director of theDivision of Banking Supervision and Regula-tion, with the concurrence of the General Coun-sel, when the proposal meets the conditionsimposed by the Board in approving previousrequests and when the specific proposal raisesno significant legal, policy, or supervisory issues.

8. The FB’s grandfather rights were scheduled to expire onFebruary 8, 2004. The FB conducts its U.S. energy tradingbusiness through FB Energy and FB’s London branch.

9. An emission allowance is an intangible right to emitcertain pollutants during a given year or any year thereafterthat is granted by the U.S. Environmental Protection Agencyor comparable foreign regulatory authority to an entity—suchas a power plant or other industrial concern—affected byenvironmental regulation aimed at reducing emission of pol-lutants. An allowance can be bought, sold, or exchanged byindividuals, brokers, corporations, or government entities thatestablish an account at the relevant governmental authority.

Emissions allowances are stored and tracked in the recordsof the relevant government authority. Accordingly, there is notransportation, environmental, storage, or insurance risk asso-ciated with ownership of emissions allowances.



3920.0.2 TRADING IN CERTAINPHYSICAL COMMODITIES NOTAPPROVED BY THE CFTC FORTRADING ON A FUTURESEXCHANGE

The Board had previously conditioned its noticeapprovals to engage in physical commoditytrading (PCT) based on commitments made bythe FHCs to trade only in commodities forwhich derivative contracts had been approvedfor trading on a futures exchange by the CFTC,unless the commodity was specifically excludedor approved by the Board (Approved Commodi-ties Commitment). This commitment provided ameans to ensure that the PCT remained comple-mentary to the financial activity of commodityderivatives activities (CDAs) because it helpeddemonstrate that there was a derivatives marketfor the underlying commodity. This commit-ment also was intended to prevent FHCs fromdealing in finished goods and other items, suchas real estate or industrial products that lackedthe fungibility and liquidity of exchange-tradedcommodities.

In another request, a foreign-domiciled FHC,RB, requested the Board’s approval under sec-tion 4 of the BHC Act, and the Board’s Regula-tion Y, to engage in limited PCT. That requestled to the Board’s decisions with regard to trad-ing of certain physical commodities, which arenot CFTC-approved for trading on a futuresexchange. The Board determined that, subject tocertain requirements, an FHC may take deliveryof certain commodities that have not beenapproved by the CFTC, if those commoditiesare similarly fungible and liquid, and do notexpose the FHC to significant additional risk.

3920.0.2.1 Commodities Approved forTrading on Non-U.S. Exchanges.

The Board has previously used CFTC-approvalof a commodity for trading on a U.S. futuresexchange as a test to determine whether aderivative or the underlying commodity is liq-uid and fungible. For some liquid and fungiblecommodities, however, no market-maker hadsought CFTC approval because of the presenceof an established foreign trading market, whichcould deter a U.S. exchange from listing a simi-lar product. The absence of CFTC approval, inthose cases, generally would not indicate thattaking and making physical delivery of the com-modity would entail substantially greater risksthan taking and making delivery of a CFTC-approved commodity. A derivatives contract

that is based on a commodity that trades on anon-U.S. exchange may be subject to a regula-tory structure comparable to the one adminis-tered by the CFTC. Such a structure generallyshould be sufficient to demonstrate that (1) thereis a market in financially settled contracts on thecommodities, (2) the commodity is fungible,and (3) a reasonably liquid market for the com-modity exists.

3920.0.2.1.1 Take and Make Delivery ofNickel

RB specifically requested the Board’s approvalto take and make physical delivery of nickel,which is a metal that is widely and activelytraded on the London Metal Exchange (LME).The LME offers futures and options contractsfor aluminum, copper, nickel, tin, zinc, and cer-tain aluminum alloy contracts. The CFTC hasdetermined that the LME is subject to a regula-tory structure comparable to that administeredby the CFTC under the Commodity ExchangeAct. As a result, members of the LME mayconduct brokerage activities for U.S. customerswithout having to register with the CFTC as afutures commission merchant or otherwise com-ply with certain of the CFTC’s consumer protec-tion rules.10 Given the nature of the LME trad-ing market and the CFTC’s determination thatLME members are subject to comparable regu-latory oversight, the Board determined that FHCsthat receive approval to engage in PCT maytake and make delivery of nickel. The Boarddetermined that other FHCs that had alreadyreceived approval to engage in PCT could alsomake and take delivery of nickel, consistentwith the Approved Commodities Commitment,as a commodity that has been specificallyapproved by the Board.

3920.0.2.2 Commodities That Are NotApproved for Trading in the U.S. or onCertain Non-U.S. Exchanges

Many commodities for which derivatives con-

10. The CFTC’s Rule 30.10 permits a person affected bythe requirements contained in Part 30 of the CFTC’s rules,which relate to registration as a futures commission merchant,to petition the CFTC for an exemption from the requirementsbased on the person’s substituted compliance with a foreignregulatory structure found comparable to that administered bythe CFTC under the Commodities Exchange Act.



tracts have not been approved for trading by theCFTC or that are not traded on a non-U.S.exchange may also be commodities that haveviable markets with financially settled contractson the commodities and that satisfy fungibilityand liquidity concerns. In many cases, the exist-ence of an established over-the-counter marketobviates the need to seek CFTC approval forlisting on a futures exchange. In addition, theparticular commodity may be similar to a CFTC-approved commodity, such as a product that isderived from a CFTC- approved commodity. Inwhich case, the separate listing may be exces-sive because market participants can use deriva-tives contracts on the CFTC-approved commod-ity to hedge their positions in the non-CFTC-approved derivative product.

The Board believes that taking and makingphysical delivery of non-CFTC-approved com-modities may be consistent with the PCT author-ity if an FHC can demonstrate that (1) there is amarket in financially settled contracts on thosecommodities in addition to the physically settledcontracts, (2) the particular commodity is fun-gible, and (3) the market for the commodity issufficiently liquid. In addition, the FHC mustdemonstrate that it has established trading limitsin place that address both concentration risk andoverall exposure to the commodity to ensurethat the FHC could physically trade in thesecommodities without incurring significant addi-tional risk.

RB requested the Board’s approval to trade incertain natural gas liquids, oil products, andpetrochemicals. The natural gas liquids con-sisted of butane, ethane, and natural gasoline;the proposed oil products were asphalt, conden-sate, boiler cutter, residual fuel oil no. 6, kero-sene, straight run, marine diesel, and naphtha;and the proposed petrochemicals were ethylene,paraxylene, styrene, propylene, and toluene (col-lectively, PCs). Contracts on those PCs are notapproved by the CFTC for trading on a U.S.futuresexchangeoronamajornon-U.S. exchange.Nonetheless, the following considerations pro-vided the Board support for making a determi-nation that trading in the PCs should be permit-ted as part of the PCT authority.

3920.0.2.2.1 Market in FinanciallySettled Contracts

Many commodities trade on established alterna-tive trading platform(s) or ATPs that are used by

a wide variety of market participants, ratherthan on a futures exchange. If derivatives con-tracts on a commodity trade on a recognizedATP, that activity could serve as sufficient evi-dence that a market in financially settled con-tracts on the particular commodity exists. Finan-cially and physically settled contracts for all thePCs trade on recognized ATPs.

The natural gas liquids are traded on theIntercontinental Exchange (‘‘ICE’’) and on theNew York Mercantile Exchange (‘‘NYMEX’’)electronic trading platforms; the distillate andresidual oil products trade on ICE and NYMEX;and the petrochemicals are traded on the Chem-connect electronic trading platform. These ATPsare major platforms that are widely used by avariety of producers, consumers, and traders ofthe PCs.

3920.0.2.2.2 Fungibility

To ensure that a commodity is fungible, an FHCmust demonstrate that no specification of exactproduct or lot would be included for contractson the commodity. The physical asset that maybe delivered to satisfy a contract would be, bynature or usage of trade, the equivalent of anyother unit of the asset. The PCs, which trade onICE, NYMEX, and Chemconnect, are fungiblebecause market participants contract for specificquantities of the commodity but cannot specifythe particular product they will receive.

3920.0.2.2.3 Liquidity

To ensure that the market for a particular com-modity is sufficiently liquid, an FHC must dem-onstrate that an active trading market in thecommodity exists that would allow the institu-tion to limit its position in the commodity rela-tive to the volume that trades in the marketgenerally. The following factors indicate that areasonably liquid market exists: (1) reliable trad-ing volume in the commodity or productionstatistics exist that demonstrate the size of themarket in the commodity; (2) daily or intradayprice data on the commodity are published; and(3) a number of market makers in the commod-ity stand ready to buy or sell the commodityeach day at published bid and offer quotations.Each of the PCs is derived from CFTC-approved commodities (natural gas and oil) andis used, similar to CFTC approved commodi-ties, as fuel or as inputs for finished products.The PCs are traded widely through brokers onthe previously discussed ATPs and are physi-



cally traded at various hubs in the U.S. andabroad.11 The ATPs post daily prices for boththe buy and sell offers on which the PCs trade.

3920.0.2.2.4 Trading Limits

An FHC that proposes to trade in a new com-modity must demonstrate that it has establishedappropriate limits on its trading in the commod-ity and has a risk-management program in placeto monitor compliance with those limits, whichmust include both concentration limits and over-all exposure limits. RB represented that as partof its risk-management program relating to thePCs, it would impose appropriate concentrationand overall exposure limits for each of the PCs.

In light of the characteristics of the PCs andbased on all the facts of record, the Board hasdetermined that taking physical delivery of thePCs is consistent with the complementary natureof PCT and does not present undue safety andsoundness concerns for RB.12

3920.0.2.2.5 Altering Commodities.

Previously, the Board approved PCT, on a lim-ited basis, subject to a number of commitments,including that the FHC not process, refine, orotherwise alter a commodity. RB intends toengage third parties to refine, blend, or other-wise alter commodities for which it is permittedto take and make physical delivery.

A number of considerations supported theBoard’s determination that engaging a thirdparty to alter a commodity is consistent with theexisting PCT authority. Permitting RB to engagea third party to alter a commodity would notsignificantly increase the risks to the institutionfrom PCT. Under this authority, an FHC mayalready engage a third party to store commodi-ties, which exposes an FHC to substantially thesame types of risks as engaging a third party toalter a commodity. Also, an FHC could sell acommodity to a refinery and buy back the refinedcommodity if both the commodity sold to and

bought from the refinery were permissible com-modities. Permitting an FHC to engage thirdparties to alter commodities also would enhancean FHC’s ability to meet its customers’ needs.

To ensure that the activity remains consistentwith the scope of PCT, RB made the followingcommitments: (1) RB will not alter commodi-ties itself; (2) both the commodity input and theresulting altered commodity will be permissiblecommodities under the Board’s decisions; and(3) RB will not have exclusive rights to use thealteration facility. Requiring that both the com-modity input and the altered commodity be per-missible commodities under the Board’s deci-sions helps ensure that RB would not assumethe risk of taking and making physical deliveryof commodities that the Board has not yet evalu-ated. In addition, preventing RB from havingthe exclusive right to use an alteration facilityshould reduce RB’s exposure to the potentialrisks associated with operating commodity-altering facilities.

3920.0.2.2.6 Risks of Proposed PhysicalCommodity Trading Activities.

Permitting RB to engage in the limited amountand types of PCT described above would notappear to pose a substantial risk to RB, deposi-tory institutions, or the U.S. financial systemgenerally. RB made commitments relating to itsPCT that are designed to address the risksinvolved in the proposed activities. In additionto the commitments discussed previously, RBprovided substantially the same commitmentsand agreed to the same limitations as thoseprovided by other FHCs in connection with theBoard’s approvals of their proposals to engagein PCT. With regard to RB and its Board order,see also subsection 3920.0.4.

3920.0.3 ENERGY MANAGEMENTSERVICES AS A COMPLEMENT TO AFINANCIAL ACTIVITY

A foreign-owned FHC, for the purposes of theBHC Act, a directly owned foreign bank, and itsother directly owned foreign companies (all col-lectively referred to as ‘‘F’’), requested theBoard’s approval under section 4 of the BHCAct (12 U.S.C. 1843) and the Board’s Regula-tion Y to provide energy management services(EMS) to owners of power generation facilities

11. Natural gas liquids are physically traded in the U.S. athubs in Texas and Kansas; the distillate and residual oilproducts are physically traded at various points in the UnitedStates as well as the Caribbean, Africa, Europe, and Sin-gapore; and the petrochemicals are physically traded at vari-ous points in the U.S., South Korea, and Thailand.

12. Because trading of the proposed commodities mightrequire that an FHC adapt a particular risk-management pro-gram beyond what would be required to trade in the commodi-ties that are currently permissible, the Board’s order does notgrant authority to take and make delivery of the proposedcommodities to all FHCS with PCT authority.



under energy management agreements (EMAs);an activity that is complementary to the finan-cial activities of engaging as principal in com-modity derivatives and providing financial andinvestmentadvisoryservices forderivatives trans-actions.13 Providing EMS generally involvesacting as a financial intermediary for a powerplant owner to facilitate transactions relating tothe acquisition of fuel and the power plant own-er’s sale of power. Such services may also con-sist of providing advice to assist the owner indeveloping its risk-management plan.

3920.0.3.1 Provision of EnergyManagement Services

Under its EMAs, EMT, as energy manager,assists power plant owners by providing transac-tional and advisory services. The transactionalservices consisted primarily of EMT acting as afinancial intermediary, substituting its credit andliquidity for those of the owner to facilitate theowner’s purchase of fuel and sale of power.EMT’s advisory services include providing mar-ket information to assist the owner in develop-ing and refining a risk-management plan for theplant.

When providing EMS, EMT will provide ser-vices under an EMA based on a strategic frame-work that will be established by the owner. Theowner, in consultation with EMT, establishes anenergy management plan and risk-managementpolicy to govern how the generation facilityshould be operated. The energy managementplan establishes the amount of power the plantshould generate and determines how the plantwill meet its reliability obligations to the powertransmission grid. The plant owner must approveall commodity contracts, including all contractsfor the purchase of fuel or the sale of electricity.The authority to enter into power or fuel con-tracts, in some cases, may be delegated to EMT,if the contracts satisfy specific criteria that areestablished by the owner; other contracts mustbe approved by the owner. The owner alsomaintains the right, subject to EMT’s right offirst refusal, to market and sell power directly tothird parties. The owner ultimately retains all

decision-making authority, including decisionsrelating to the facility’s generation output and,in particular, whether the facility should be shutdown for any period of time.

An EMA’s compensation structure includesthis allocation of responsibilities. When thefacility is in operation, EMT is typically com-pensated on a monthly basis at the greater of amonthly fixed fee or a stated percentage of thespread between delivered fuel prices and therealized power revenues (adjusted to reflect cer-tain fees and costs). When the facility is not inoperation, EMT is not responsible for the fixedcosts of the facility and is not entitled to rev-enues or other compensation, apart from themonthly fees.

EMT is not involved in providing day-to-dayoperational services to the facility. Those tasksare generally performed by the owner or by anoperator who is hired directly by the owner andis not affiliated with EMT. The operator man-ages and maintains the facility on a daily basis,which typically includes providing labor andsupport services. The operator is to provideEMT with information on the operating statusof the facility, maintenance issues that mightaffect the availability of the facility to generatepower, and scheduled outage and maintenanceperiods.

EMT may buy fuel for the facility from thirdparties and enter into a mirror transaction for thefuel with the owner. The owner may then sellthe power generated by the facility to EMT, andthen EMT generally resells the power in themarket. EMT would thus be acting as the finan-cial intermediary for the owner, providing creditand liquidity support, including posting anyrequired collateral for transactions. Because EMTis able to substitute its name and credit ratingfor the owner’s, the terms of the transactionsmay be generally more favorable than what theowner could negotiate on its own.

EMT assumes responsibility for administra-tive tasks related to the fuel and power transac-tions so that the owner does not have to main-tain an administrative infrastructure to supportits transactions with third parties. The servicesinclude (1) arranging for third parties to providefuel transportation or power transmission ser-vices, (2) scheduling those services, and resolv-ing any resulting imbalances; (3) ensuring thatfuel deliveries and power sales are properlycoordinated; (4) negotiating contracts with, andmonitoring the credit support and collateralrequirements of, the owner’s counterparties;(5) assisting in complying with power tariffs;and (6) paying fuel suppliers. EMT also mayenter into transactions with third parties as nec-

13. In connection with an acquisition of a marketing andtrading entity, F received approval to engage in the U.S. inlimited PCT activities, as an activity that is complementary toa financial activity of engaging in CDAs. The marketing andtrading entity, now EMT, also served as an energy managerunder EMAs with several power generators.



essary to ensure that the owner meets its powergeneration obligations to the power grid inaccordance with the energy-management plan.

Risk-management and hedging services mayalso be provided by EMT to the owner in con-nection with both the purchase of fuel and thesale of power. These transactions may be enteredinto with third parties back to back (with EMTin the middle) or may consist of direct hedgingtransactions between the owner and EMT. EMTwould retain the risk that the owner is hedging.For the first type of transaction, the owner wouldinform EMT of its intention to hedge the priceof fuel or power for a specified term, and EMTwould then solicit bids or offers. After review-ing the competing bids or offers, the ownerwould make a selection and direct EMT to enterinto the transaction with that counterparty. EMTand the owner then would enter into a mirrortransaction so that EMT would not retain anyrisk exposure on the overall transaction. For thesecond type of transaction, EMT would submitthe offer for a hedging transaction to the owner,who can accept or reject the offer. If the owneraccepts, EMT may enter into the transactiondirectly with the owner. All these transactionswould be governed by the International Swapsand Derivatives Association’s master agree-ments between the owner and EMT. The ownermay also enter into hedging transactions directlywith a third party without EMT’s involvement.

EMT may generally provide two types ofmarket information services to the owner. First,EMT may provide market and risk informationto assist the owner in developing its risk-management plan and strategy. As a direct mar-ket participant, EMT has access to informationthat may help the owner refine its risk-management strategies. Second, EMT may pro-vide the owner with day-to-day market informa-tion that the owner, in consultation with theoperator of the power facility, may use to deter-mine its short-term dispatch guidelines (that is,the amount of power the facility should generateto meet its contractual requirements and relia-bility obligations).

3920.0.3.2 Energy Management Servicesis Complementary

The Board concluded that the provision of EMSis complementary, within the meaning of theGLB Act, to the financial activities of providingcommodity derivatives activities (CDAs) andDerivatives Advisory Services (DAS). EMSwould add to these financial activities a numberof agency and administrative services that would

facilitate providing CDAs and DAS on behalf ofa plant owner. The combination of servicescomplements and enhances F’s CDAs and DASby allowing F to offer power plant owners anintegrated approach to managing the commodity-related aspects of their business. Some non-BHC participants in the energy trading markets,including diversified financial services compa-nies, offer EMS to clients in connection withtheir commodity derivatives business. Thosecompanies can, and regularly do, provide EMSto owners. The Board’s permitting FHCs toprovide EMS would enable FHCs to offer thesame integrated services that are provided by anumber of their competitors. The Board thusconcluded that F’s EMS complement its CDAsand DAS.

3920.0.3.3 Limitations on EnergyManagement Services

In order to limit the size, scope, and safety andsoundness risks of EMS, F committed that therevenues attributable to EMS would not exceed5 percent of F’s total consolidated operatingrevenues.14 In addition, F’s authority to provideEMS is subject to several conditions that limitF’s responsibilities and potential liabilities itmay assume under an EMA. Specifically, F mayonly act as energy manager if the relevant EMAprovides that:

• the owner retains the right to market and sellpower directly to third parties, which may besubject to the energy manager’s right of firstrefusal;

• the owner retains the right to determine thelevel at which the facility will operate (i.e., todictate the power output of the facility at anygiven time);

• neither the energy manager nor its affiliatesguarantee the financial performance of thefacility; and

• neither the energy manager nor its affiliatesbear any risk of loss if the facility is notprofitable.

The Board determined that permitting F toengage in EMS in the limited amounts andsituations described previously would not appear

14. Total operating revenues are defined as net income andall non-interest revenue, net securities gains and losses butexcluding extraordinary income.



to pose a substantial risk to F, depository institu-tions, or the U.S. financial system generally. F,acting as an energy manager, would enter intothe same type of commodity derivatives transac-tions that other FHCs had been permitted toenter into; only it would enter into these transac-tions to facilitate the business strategies of athird-party owner.

Based on all the facts of record that werepresented, including the representations and com-mitments made by F within its notice to theBoard, and those commitments and conditionscontained in the order, the Board approved thenotice on December 4, 2007. (The previousdiscussion is only a summary. See the full textof the Board order at 2008 FRB C20.)

3920.0.4 Energy Tolling Services As AComplement To A Financial Activity

A foreign bank, R Bank (RB), a financial hold-ing company (‘‘FHC’’) for purposes of the BankHolding Company Act (‘‘BHC Act’’), requestedthe Board’s approval under section 4 of theBHC Act (12 U.S.C. 1843) and the Board’sRegulation Y (12 C.F.R. 225) to engage in lim-ited PCT and the providing of EMS for ownersof power generation facilities under EMAs. RBhas requested the Board’s approval to engage inphysically settled energy tolling (ET) by enter-ing into tolling agreements (TAs) with powerplant owners as an activity that is complemen-tary to the financial activity of engaging asprincipal in commodity derivatives transactions.The Board previously determined PCT and EMSto be activities that are complementary to thefinancial activity of engaging as principal incommodity derivative transactions, and in thecase of EMS, also complementary to providingfinancial and investment advisory services forderivative transactions. The Board has not previ-ously considered whether the requested ET iscomplementary to a financial activity under sec-tion 4 of the BHC Act for a FHC. RB intends toengage in such complementary activities througha joint venture company (JV) formed with SE,to be located in the U.S. and to operate as anenergy services company. Certain existing TAswould be transferred to the JV.

3920.0.4.1 FHC’S Proposal

RB operates in the U.S. through CFG Corp., amultibank holding company, as well as throughU.S. domiciled branches and representativeoffices.15 RB also operates U.S. domiciled non-banking companies in the United States, includ-ing a broker-dealer subsidiary, RB-GC.

3920.0.4.2 Physical Commodity Trading

RB intends to expand its commodity-relatedactivities by forming a JV with S Corp. (S). Asubsidiary of S, TE Corp. (TE), which engagesin commodity derivatives transactions and PCT,would be transferred to the JV.16 TE acts asprincipal in commodity transactions in and out-side the U.S., taking and making physical deliv-ery of commodities in connection with thosetransactions. TE also acts as an energy managerand enters into TAs with power plant owners.RB plans to engage in PCT, EMS, and ET underthe complementary activity authority of section4 of the BHC Act so that the ET companiestransferred to the JV can continue to conductthose activities.17 RB engages in CDAs in theU.S. and plans to expand those activities andengage in PCT through the JV. The JV’s activi-ties would include taking or making delivery ofpermissible commodities pursuant to physicallysettled commodity derivatives; taking inventorypositions in natural gas, oil, emissions allow-ances, and other permissible commodities; andengaging in other spot market trading activities.RB has also indicated that JV might engage incommodity-relatedfinancing transactions, includ-ing volumetric production payment transactions(VPPs).18

15. RB holds a 38 interest in RF, an FHC formed by agroup of banking organizations, including F and certain of itsaffiliates.

16. JV plans to purchase TE and its related energy tradingsubsidiaries and affiliates (″TE Companies″), which wouldbecome JV’s subsidiaries.

17. RB committed that within two years of consummationof the transaction, it will conform, including by divestiture ifnecessary, any activities that are impermissible for an FHCunder the BHC Act or that are inconsistent with the activitiespermitted under this order.

18. RB may engage in VPPs on oil and gas as permissiblecredit transactions if it agrees to sell the oil or gas it receivesunder the VPP to third parties before delivery. VPPs are ameans of financing oil and gas exploration and production.Under a VPP, the lender or VPP holder provides an up-frontpayment in exchange for a royalty interest that entitles theVPP holder to receive hydrocarbons on a regular basis duringthe life of the VPP transaction in quantities that will allow theVPP holder to recover its up-front payment and a specifiedreturn. The Board’s General Counsel has determined thatVPPs generally are considered extensions of credit permis-



The Board had previously determined thatPCT is a permissible activity because it comple-ments the financial activity of engaging in CDAs.Most of the transactions in which RB is toengage as part of PCT would not differ fromtransactions that the Board has previouslyapproved. RB plans to engage, however, in awider set of transactions under the PCT author-ity and therefore requested confirmation thatthose activities are within the scope of thatauthority. Specifically, RB plans to enter intolong-term power supply contracts with largecommercial and industrial (C&I) end-users; toengage in PCT for which derivatives contractshave not been approved by the CFTC for trad-ing on a U.S. exchange or specifically approvedby the Board; and to enter into contracts withthird parties to process, refine, or otherwise altercommodities.

3920.0.4.3 Long-Term Electricity SupplyContracts

RB plans, as part of its energy trading business,to enter into long-term electricity supply con-tracts with large C & I customers. The currentPCT authority permits an FHC to take a positionin a commodity and does not limit the durationof, or counterparties to, an FHC’s contracts.Most commodities in which an FHC may tradeunder the PCT authority tend by their nature tobe limited to the wholesale market. Electricity,however, has a greater potential to be sold notonly to end-users generally but also to smallretail customers who are unlikely to be partici-pants in the market for energy related deriva-tives products.

To ensure that RB’s activities remain consis-tent with the general complementary nature ofthe activities permitted, RB committed to enterinto long-term supply contracts only with largeC & I customers. The market risk relating tothese long-term contracts would be handledusing the same methodologies that are used forother electricity trades. RB represented that inall states where the electricity market has beenderegulated, state regulations distinguish amongtypes of end-users, generally relying on the cus-tomer’s typical electricity consumption level.To ensure that RB contracts only with custom-ers who are sufficiently large and sophisticated,RB committed that it will enter into long-termelectricity supply contracts only with C & Icustomers that consume electricity at a rate of at

least (1) 800 megawatt-hours/year (‘‘MWHrs/year’’) or (2) the minimum consumption levelfor large C & I customers under applicable statelaw, whichever is greater. This restriction shouldbe sufficient to ensure that RB transacts withfinancially sophisticated purchasers (and notwith retail purchasers) and thus RB would remainessentially a wholesale intermediary.

3920.0.4.4 Energy Tolling Agreements

TE, as toller, pays the plant owner a fixed peri-odic payment that compensates the owner for itsfixed costs (‘‘capacity payments’’), usuallymonthly, in exchange for the right to all or partof the plant’s power output. The plant owner,however, retains control over the day-to-dayoperations of the plant and physical plant assetsat all times.19 The toller provides (or pays for)the fuel needed to produce the power that itdirects the owner to produce. The fuel andenergy transactions that the toller enters into inthese circumstances are generally physicallysettled.20 The agreements also generally providethat the owner will receive a marginal paymentfor each megawatt hour produced by the plant tocover the owner’s variable costs plus a profitmargin. The toll is similar to a call option on thepower produced by the plant with a strike pricelinked to fuel and power prices. In general, thetoller would direct the operator to run the plant(i.e., the toller would exercise its option) whenthe price of power exceeds the cost of producingthat amount of power. Some TAs may also givethe toller the right to a plant’s excess capacity,which the toller may sell to the market or use tomeet reliability obligations to the power grid.

3920.0.4.5 Risks of Energy Tolling

The primary risk to a toller is that the plantproves to be uneconomical to operate, whichcan occur when the cost of producing power isgreater than the power’s market price. In thosecases, the toller has no ability to recover its

sible for a BHC under section 225.28(b)(1) of Regulation Y, ifthe BHC agrees to sell the commodities before delivery.

19. RB has indicated that TE’s TAs are all medium term(generally two to five years), although some market partici-pants enter into longer-term agreements. TE has not enteredinto longer-term contracts because it can be difficult to hedgeexposure over a longer period of time.

20. Because an FHC would generally take or make physi-cal delivery of fuel and electricity in connection with a TA, anFHC would need approval to engage in PCT to engage in ET.



capacity payments. To limit the potential safetyand soundness risks of ET, RB has committedthat it will limit the amount of its ET activities.Currently, all PCT activities are limited to amaximum of 5 percent of the FHC’s tier 1capital. RB committed to include the presentvalue of its future committed capacity paymentsunder a TA in calculating the value of commodi-ties held by RB under its Physical CommodityTrading authority to determine compliance withthe cap of 5 percent of tier 1 capital. As a result,allowing RB to engage in ET activities wouldnot increase the overall position that it may takein physical commodities. This limit would alsoensure that ET remains limited in size and scoperelative to RB’s financial activities.

3920.0.4.6 Energy Tolling isComplementary

Energy Tolling is an outgrowth of the existingfinancial activity of a BHC-FHC engaging inCDAs. Energy tolling complements CDAs by

allowing an FHC to hedge its own, or assist itsclients to hedge, positions in energy. An FHCengaging in authorized energy tolling wouldalso provide an FHC with additional informa-tion on the energy markets that would help theFHC manage its own commodity risks. TheBoard also notes that financial institution com-petitors of RB that are not FHCs engage intolling activities as part of their energy tradingoperations. Based on the foregoing and all otherfacts of record, the Board concluded that RB’sET activities complement its CDAs.

Based on all the facts of record, includingRB’s representations and commitments that weremade to the Board in connection with its notice,and the terms and conditions set forth in theBoard’s order, the Board approved the FHC’snotice. The Board’s determination is also sub-ject to all the conditions set forth in RegulationY. The Board order was approved on March 27,2008. (The previous discussion is only a sum-mary. See the full text of the Board order at2008 FRB C60.)



Limited commodity-trading activities involvinga particular commodity,such as natural gas andelectricity, that comple-ment the financial activityof engaging regularly asprincipal in BHC-permissible commodityderivatives based on thatcommodity.

1843(k)(1)(B) 225.89 4-056.8 2003 FRB 5082004 FRB 2152004 FRB 511

Limited commodity trad-ing in Energy-related com-modities (natural gas,crude oil, electricity, andemmissions allowances) asa complement to a finan-cial activity

1843(k)1)(B) 2006 FRB C542006 FRB C572006 FRB C113




Commodities not approvedby the CFTC for tradingon a U.S. futures exchange(e.g., nickel on LondonMetal Exchange) or oncertain non-U.S. exchanges

2008 FRB C60

Engaging third parties toalter commodities.

2008 FRB C60

Providing energy manage-ment services as a comple-ment to financialactivities—providing com-modity derivatives activi-ties and derivatives advi-sory services

2008 FRB C20

Providing energy tollingservices as a complementto a financial activity

2008 FRB C60





Insurance Sales Activities and Consumer Protection in Salesof Insurance (Sections 4(k) and 4(c)(8) of the BHC Act) Section 3950.0

Banking organizations have long been engagedin the sale of insurance products and annuities,although these activities historically have beensubject to several restrictions. For example, untilrecently, national banks could sell most types ofinsurance, but only through an agency located ina small town. Bank holding companies werealso permitted to engage in only limited insur-ance agency activities under the Bank HoldingCompany Act. State-chartered banks, on theother hand, generally have been permitted toengage in insurance sales activities as agent tothe extent permitted by state law.

The Gramm-Leach-Bliley Act of 1999 (theGLB Act), however, authorized bank holdingcompanies that make an effective election tobecome a financial holding company (FHC) tounderwrite and sell any type of insurancenationwide. In addition, the GLB Act authorizednational banks and state-chartered member banksto sell all types of insurance products through afinancial subsidiary. The GLB Act generally didnot change the powers of banks to sell insur-ance directly.As a result of the GLB Act andmarketplace developments, many banking orga-nizations are increasing the range and volume oftheir insurance and annuities sales activities.

To the extent permitted by applicable law,banking organizations may conduct insuranceand annuity sales activities through a variety ofstructures and delivery channels, including own-ership of an insurance underwriter or an insur-ance agency or broker, the employment by abank of licensed agents, a joint marketingarrangement with a producer,1 independent agentslocated at a bank’s office, direct mail, telemar-keting, and Internet marketing.

A banking organization may also conductinsurance or annuity sales activities through amanaging general agent (MGA). An MGA is awholesaler of insurance products and services toinsurance agents. The MGA has a contractualagreement with an insurance carrier to assume

functions for the carrier, which may includemarketing, accounting, data processing, policyrecordkeeping, and monitoring or processingclaims. The MGA may rely on various localagents or agencies to sell the carrier’s products.Most states require an MGA to be licensed.

3950.0.1 OVERVIEW AND SCOPE

The following guidance pertains to bank hold-ing companies (BHCs) (including FHCs) andstate member banks that are either directly orindirectly engaged in the sale of insurance orannuity products as agents. As noted above, theGLB Act amended the BHC Act to allow aBHC or foreign bank that qualifies as an FHC toengage in a broad range of insurance activities,including underwriting or selling (as agent orbroker) any type of insurance and issuing andselling annuities, in any state.

BHCs that are not FHCs may sell or under-write insurance as a principal, agent, or brokeronly to the limited extent authorized, before theGLB Act, under section 4(c)(8) of the BHC Actand section 225.28(b)(11) of Regulation Y. Forexample, a BHC that is not an FHC may under-write and sell insurance (including home mort-gage redemption insurance) that is directly relatedto an extension of credit by the BHC or any ofits subsidiaries and that is limited to ensuringrepayment of the outstanding balance due on theextension of credit in the event of the death,disability, or involuntary unemployment of thedebtor. A BHC that is not an FHC can also sellany type of insurance as agent in a town if thetown has a population of 5,000 or less and theBHC or a subsidiary has a lending office in thesmall town. (See section 3170.0.)

The GLB Act permits state member banksthat are not authorized by applicable state law tosell insurance directly through a financial sub-sidiary.2 A financial subsidiary engaged in insur-ance sales may be located wherever state lawpermits the establishment and operation of aninsurance agency. Such subsidiaries, however,would be subject to state licensing and otherrequirements. The examination guidance foundin this section is limited to insurance and annu-

1. The term ‘‘producer’’ refers broadly to persons, partner-ships, associations, limited liability corporations, etc., thathold a license to sell or solicit contracts of insurance to thepublic. Insurance agents and agencies are producers who,through a written contractual arrangement known as a directappointment, represent one or more insurance underwriters.Independent agents and agencies are those producers that sellproducts underwritten by one or more insurance underwriters.Captive agents and agencies represent a specific underwriterand sell only its products. Brokers are producers that representthe purchaser of insurance and obtain bids from competingunderwriters on behalf of their clients. State insurance lawsand regulations often distinguish between an insuranceagent and a broker; in practice, the terms are often usedinterchangeably.

2. Rules pertaining to state member bank financial subsidi-aries are found in the Board’s Regulation H (12 C.F.R.208.71–77).


ity salesactivities. Because this section focusesonly on insurance sales activities, it does notaddress insurance underwriting (that is, as prin-cipal) activities of FHCs or the limited insurance-underwriting powers of BHCs or state memberbanks. Examiner guidance on performing appro-priate risk assessments for insurance and annu-ity sales activities of BHCs (including FHCs)and state member banks is included.3

Additionally, guidance is provided for exam-ining a state member bank for compliance withthe consumer protection rules relating to insur-ance and annuities sales activities that are con-tained in the Board’s December 2000 revisionsto Regulation H (subpart H) (12 C.F.R. 208.81–86), ‘‘Consumer Protection in Sales of Insur-ance’’ (CPSI). Subpart H, which became effec-tive October 1, 2001, implements the insuranceconsumer protection requirements of the GLBAct, which are codified at 12 U.S.C. 1831x. (See65 Fed. Reg.75841 (December 4, 2000)). Theregulation applies not only to the sale of insur-ance products or annuities by the state memberbank but also to activities of any person en-gaged in insurance product or annuity sales onbehalf of the state member bank, as discussed inthis guidance. The guidance is generally notapplicable to debt-cancellation contracts anddebt-suspension agreements, unless these prod-ucts are considered to be insurance products bythestate inwhich thesalesactivitiesareconducted.

The Federal Reserve is responsible for evalu-ating the consolidated risk profile of a BHC orstate member bank, including determining therisks posed to the BHC or state member bankfrom the insurance sales activities it conducts,directly or indirectly, and determining the effec-tiveness of its risk-management systems. TheGLB Act also established a regulatory frame-work that is designed to ensure that the FederalReserve coordinates with, and relies to the extentpossible on information from, the state insur-ance authorities when it is supervising the insur-ance activities conducted by a BHC or statemember bank through a functionally regulatedsubsidiary.

Consistent with the Federal Reserve’s risk-focused framework for supervising bankingorganizations, resources allocated to the reviewof insurance sales activities should be commen-surate with the significance of the activities andthe risk they pose to the banking organization.The scope of the review depends on the signifi-cance of the activity to the BHC or state mem-ber bank and on the extent to which the bank isdirectly involved in the activity. Examiner judg-ment is required to tailor the reviews, as appro-priate, on the basis of the legal, organizational,and risk-management structure of the BHC’s orstate member bank’s insurance sales activitiesand on other relevant factors.4

3950.0.2 SUPERVISORY APPROACHFOR THE REVIEW OF INSURANCEAND ANNUITY SALES ACTIVITIES

3950.0.2.1 Supervisory Objective

The primary objective of the review is to deter-mine the level and direction of risk to a BHC orstate member bank from its insurance salesactivities, including insurance sales activitiesconducted directly, by or in conjunction with asubsidiary or affiliate, or through a third-partyarrangement. Primary risks that may arise frominsurance sales activities include operational,legal, and reputational risk. If the BHC or statemember bank does not adequately manage theserisks, they could have an adverse impact on aBHC’s or state member bank’s earnings andcapital. The examiner should produce (1) a riskassessment that summarizes the level of inher-ent risk to the BHC or state member bank byrisk category and (2) an assessment of theadequacy of board of directors and managementoversight of the activity, including the activity’sinternal control framework. For those state mem-ber banks selling insurance or annuity products,or that enter into arrangements under whichanother party sells insurance or annuity productsat the bank’s offices or on behalf of the bank, asecond objective of the review is to determinethe bank’s compliance with the consumer pro-tection provisions of the GLB Act and the CPSIregulation.

3. The term ‘‘risk assessment’’ denotes the work productdescribed in SR-97-24, ‘‘Risk-Focused Framework for Super-vision of Large Complex Institutions,’’ and entails an analysisof (1) the level of inherent risk by type of risk (operational,legal, market, liquidity, credit, and reputation risk) for abusiness line or business function, (2) the adequacy of man-agement controls over that business line or business function,and (3) the direction of the risk (increasing, decreasing, orstable).

4. See SR-02-01, ‘‘Revisions to Bank Holding CompanySupervision Procedures for Organizations with Total Consoli-dated Assets of $5 Billion or Less,’’ and section 1000.1 of theCommercial Bank Examination Manualfor a discussion ofthe Federal Reserve’s risked-focused examinations and therisk-focused supervision program for community bankingorganizations. See also SR-97-24.

Insurance Sales Activities and Consumer Protection in Sales of Insurance 3950.0


3950.0.2.2 State Regulation of InsuranceActivities

Historically, insurance activities have primarilybeen regulated by the states. In 1945, Congresspassed the McCarran-Ferguson Act, whichgranted states the power to regulate most aspectsof the insurance business. The McCarran-Ferguson Act states that ‘‘no act of Congressshall be construed to invalidate, impair, orsupersede any law enacted by any state for thepurpose of regulating the business of insurance,or which imposes a fee or tax upon such busi-ness, provided the Act shall be applicable to thebusiness of insurance to the extent that suchbusiness is not regulated by State law’’ (15U.S.C. 1012(b)).

State regulation of insurance producers iscentered on the protection of the consumer andconsists primarily of licensing and continuingeducation requirements for producers. A pro-ducer generally must obtain a license from eachstate in which it sells insurance and for eachproduct sold. Each state in which a producersells insurance has regulatory authority over theproducer’s activities in the state.

The GLB Act does include several provisionsthat are designed to keep states from (1) unfairlyregulating a BHC or bank to prevent it fromengaging in authorized insurance activities or(2) otherwise discriminating against BHCs andbanks engaged in insurance activities. Theseprovisions are complex and beyond the scope ofthis guidance. It should be noted, however, thatthe GLB Act generally does not prohibit a statefrom requiring a BHC or bank, or its employeesengaged in insurance sales, solicitation, or cross-marketing activities, to be licensed within thestate.

State insurance regulatory authorities do notconduct routine, periodic examinations of aninsurance producer. A state examination of aninsurance producer is generally conducted onlyon an ad hoc basis and is primarily based on thevolume and severity of consumer complaints.The state examination may also be based in parton the producer’s market share and on previousexamination findings. Additionally, a review ofa producer would typically not assess its finan-cial condition.

State market conduct examinations of insur-ance sales practicesare focused at the insurance-underwriter level.5 The insurance underwriter is

generally held accountable for compliance withstate insurance laws to protect the consumerfrom the unfair sales practices of any producerthat markets the insurance underwriter’s prod-ucts. Market conduct examinations of an insur-ance underwriter may potentially uncover a con-cern about a particular producer, such as abank-affiliated producer.6 However, in the past,a state insurance regulatory authority has nottypically examined a producer unless the insur-ance underwriter owns the producer.

Generally, market conduct examinationsinclude reviews of insurance underwriters’ com-plaint handling, producer licensing, policyholderservice, and marketing and sales practices. Typi-cally, a state authority will direct a correctiveaction for insurance sales activity at the under-writer. The states generally have specific guid-ance for their market conduct examinations oflife, health, and property/casualty7 lines of busi-ness guidance that corresponds to regulationsrelated to advertising, misrepresentations, anddisclosures for these different business lines.The reports of examination issued by the stateinsurance departments are usually available tothe public.

Because the underwriter, not the producer, isliable to the insured, the failure of an insuranceproducer generally would not result in financialloss to consumers or state guarantee funds. Con-sequently, there are no regulatory capitalrequirements for insurance producers, nor dostates require regulatory reporting of financialstatement data on insurance producers. Whilethe underwriter is ultimately liable to the insured,in some instances a producer and its owner maybe held liable for misrepresentations, as well asfor violations of laws and regulations.

5. Generally, market conduct reviews of insurance under-writers are conducted on an ad hoc basis, triggered primarilyby the volume and severity of consumer complaints, and arebased on the underwriter’s market share or on previous exami-

nation findings. In some states, however, market conductreviews of insurance underwriters are conducted on a peri-odic, three- to five-year schedule.

6. The terms ‘‘insurance underwriter,’’ ‘‘insurer,’’ ‘‘insur-ance carrier,’’ and ‘‘insurance company’’ are industry termsthat apply similarly to the party to an insurance arrangementwho undertakes to indemnify for losses, that is, the party thatassumes the principal risk under the contract.

7. Property insurance indemnifies a person who has aninterest in a physical property for loss of the property or theloss of its income-producing abilities. Casualty insurance isprimarily concerned with the legal liability for losses causedby injury to persons or damage to the property of others. Itmay also include such diverse forms of insurance as crimeinsurance, boiler and machinery insurance, and aviation insur-ance. Many casualty insurers also underwrite surety bonds.



3950.0.2.3 Functional Regulation

Under the GLB Act, reviews by banking super-visors of insurance or securities activities con-ducted in a BHC’s or bank’s functionally regu-lated subsidiary are not to be extensions of moretraditional bank-like supervision. Rather, to theextent possible, bank supervisors are to rely onthe functional regulators to appropriately super-vise the insurance and securities activities of afunctionally regulated subsidiary. A function-ally regulated subsidiary includes any subsidi-ary of a BHC or bank that (1) is engaged ininsurance activities and subject to supervisionby a state insurance regulator or (2) is registeredas a broker-dealer with the Securities andExchange Commission. The GLB Act does notlimit the Federal Reserve’s supervisory author-ity with respect to a BHC or state member bankor the insurance activities conducted by eitherof them. The functional regulators for insurancesales activities, including the activities of insur-ance producers, consist of the insurance depart-ments in each of the 50 states, the District ofColumbia, Puerto Rico, the U.S. Virgin Islands,American Samoa, and Guam.

The GLB Act places certain limits on theability of the Federal Reserve to examine, obtainreports from, or take enforcement action againsta functionally regulated nondepository subsidi-ary of a BHC or state member bank. For pur-poses of these limitations, a subsidiary licensedby a state insurance department to conductinsurance sales activities is considered function-ally regulated only with respect to its insuranceactivities and any activities incidental to thoseactivities.8

The GLB Act indicates that the Federal Reservemust rely, to the fullest extent possible, on infor-mation obtained by the appropriate state insur-ance authority of a nondepository insuranceagency subsidiary of a BHC or state memberbank. In addition, the Federal Reserve mayexamine a functionally regulated subsidiary of aBHC or state member bank only in the follow-ing situations:

1. The Federal Reserve has reasonable cause tobelieve that the subsidiary is engaged inactivities that pose a material risk to an affili-ated depository institution, as determined by

the responsible Reserve Bank and Boardstaff.

2. After reviewing relevant information avail-able at the BHC or state member bank level(including information obtained from theappropriate functional regulator), it is deter-mined that an inspection or examination isnecessary to adequately understand and as-sess the banking organization’s systems formonitoring and controlling the financial andoperational risks that may pose a threat to thesafety and soundness of an affiliated deposi-tory institution.

3. On the basis of reports and other availableinformation (including information obtainedfrom the appropriate functional regulator),there is reasonable cause to believe that thesubsidiary is not in compliance with a federallaw that the Federal Reserve has specificjurisdiction to enforce with respect to thesubsidiary (including limits relating to trans-actions with affiliated depository institu-tions), and the Federal Reserve cannot assesssuch compliance by examining the BHC orstate member bank or other affiliated deposi-tory institution.

Other similar restrictions limit the ability ofthe Federal Reserve to obtain a report directlyfrom, or take enforcement action against, a func-tionally regulated nonbank subsidiary of a BHCor state member bank. As noted above, theseGLB Act limitations do not apply to a BHCparent company or state member bank even ifthe BHC parent company or state member bankis itself licensed by a state insurance regulatoryauthority to conduct insurance sales activities.

Staff who are conducting reviews of BHC orstate member bank insurance or annuity salesactivities should be thoroughly familiar withSR-00-13, which provides guidance on reviewsof functionally regulated BHC or state memberbank subsidiaries. Reserve Bank staff may con-duct an examination of a functionally regulatedsubsidiary, or request a specialized report from afunctionally regulated subsidiary, only afterobtaining approvals from the appropriate staffof the Board’s Division of Banking Supervisionand Regulation.

When preparing or updating the risk assess-ment of a BHC’s or state member bank’s insur-ance or annuity sales activities, Federal Reservestaff, when appropriate, should coordinate theiractivities with the appropriate state insuranceauthorities. The Federal Reserve’s supervisionof BHCs or state member banks engaged ininsurance sales activities is not intended toreplace or duplicate the regulation of insurance

8. For example, if a BHC’s nonbank subsidiary engages inmortgage lending and is also licensed as an insurance agency,it would be considered a functionally regulated subsidiaryonly to the extent of its insurance sales activities.



activities by the appropriate state insuranceauthorities.

3950.0.2.4 Information Sharing with theFunctional Regulator

The Federal Reserve and the National Associa-tion of Insurance Commissioners (NAIC)approved a model memorandum of understand-ing (MOU) on the sharing of confidential infor-mation between the Federal Reserve and indi-vidual state insurance departments.9 The Boardalso approved the delegation of authority to theBoard’s general counsel to execute agreementswith individual states, based on this MOU.Examiners should follow required Board admin-istrative procedures before sharing any confi-dential information with a state insurance regu-lator. (These procedures generally require FederalReserve staff to identify and forward to Boardstaff for review any confidential informationthat may be appropriate to share with the appli-cable state insurance regulator concerning insur-ance sales activities conducted by BHCs or statemember banks.) The Board’s Division of Con-sumerandCommunityAffairs’CPLetter2001-11outlines the procedures for sharing consumercomplaint information with state insuranceregulators.

3950.0.3 STATUTORY ANDREGULATORY REQUIREMENTS ANDPOLICY GUIDANCE

3950.0.3.1 Privacy Rule and the FairCredit Reporting Act

BHCs, state member banks, and the subsidiariesof both (other than subsidiaries that are subjectto the privacy rules of another financial regula-tor such as a broker-dealer or insurance com-pany) that sell insurance to consumers mustcomply with the privacy provisions under titleV of the GLB Act (12 U.S.C. 6801–6809), asimplemented by the Board’s Regulation P (12C.F.R. 216) (the privacy rule). Functionallyregulated BHC and state member bank nonbankinsurance agency subsidiaries are not coveredby the Federal Reserve’s privacy rule; however,they must comply with the privacy regulations(if any) issued by their relevant state insuranceregulator.

The privacy rule regulates a BHC’s or statemember bank’s treatment of nonpublic personalinformation about a ‘‘consumer,’’ that is, anindividual that obtains a financial product orservice (such as insurance) from the institutionfor personal, family, or household purposes. Theprivacy rule generally requires a BHC or bankto provide a notice to each of its customers thatdescribes the privacy policies and practices ofthe BHC or bank no later than when the BHC orbank establishes a business relationship with thecustomer. The privacy rule also generally pro-hibits a BHC or bank from disclosing any non-public personal information about a consumer toany nonaffiliated third party, unless the BHC orbank first provides to the consumer a privacynotice and a reasonable opportunity to prevent(or ‘‘opt out’’ of ) the disclosure, and the con-sumer does not opt out. The privacy rule permitsa BHC or bank to provide a joint notice withone or more of its affiliates or other financialinstitutions, as identified in the privacy noticeitself, provided that the notice is accurate withrespect to the institution and the other institutions.

While the privacy rule applies to the sharingof nonpublic personal information by a BHC orbank with nonaffiliated third parties, the sharingof certain consumer information with affiliatesor nonaffiliates may be subject to the Fair CreditReporting Act (FCRA) as well. For example,under the FCRA, if a BHC or bank wants toshare with its insurance subsidiary informationfrom a credit report or from a consumer applica-tion for credit (such as the consumer’s assets,income, or marital status), the BHC or bankmust first notify the consumer about the intendedsharing and give the consumer an opportunity toopt out. The same rules would apply to aninsurance company that wants to share informa-tion from credit reports or from applications forinsurance with an affiliate or a third party.

3950.0.3.2 Anti-Tying Prohibitions

Federal law (section 106(b) of the BHC ActAmendments of 1970 (12 U.S.C. 1972(b)) gen-erally prohibits a bank from requiring that acustomer purchase a product or service from thebank or an affiliate as a prerequisite to obtaininganother product or service (or a discount on theother product or service) from the bank. Thisprohibition applies whether the customer is retailor institutional, or whether the transaction is onbank premises or off premises. For example, a9. The NAIC is the organization of insurance regulators

from the 50 states, the District of Columbia, and the four U. S.territories. The NAIC provides a forum for the developmentof uniform policy among the states and territories. The NAICis not a governmental or regulatory body.



state member bank may not require that a cus-tomer purchase insurance from the bank or asubsidiary or an affiliate of the bank in order toobtain a loan from the bank (or a reduced inter-est rate on the loan).10 The special anti-tyingrules in section 106 do not apply to tyingarrangements imposed by a BHC or a nonbankaffiliate of a BHC.

3950.0.3.3 Policy Statement on Incomefrom Sale of Credit Life Insurance

This Federal Reserve Board policy statement(see the Federal Reserve Regulatory Serviceat3-1556) sets forth the principles and standardsthat apply to a bank’s sales of credit life insur-ance and the limitations that apply to the receiptof income from those sales by certain individu-als and entities associated with the bank. (Seesection 3170.0.4.1 and the inspection procedurerelated to this policy statement in section3170.0.6.)

3950.0.4 RISK-MANAGEMENTPROGRAM

3950.0.4.1 Elements of a SoundInsurance or Annuity Sales Program

A BHC or state member bank engaged in insur-ance or annuity sales activities should—

1. conduct insurance sales programs in a safeand sound manner;

2. have appropriate written policies and proce-dures in place that are commensurate withthe volume and complexity of its insurancesales activities;

3. obtain its board of directors’ approval of thescope of the insurance and annuity sales pro-gram and of written policies and proceduresfor the program;

4. effectively oversee the sales program activi-ties, including third-party arrangements;

5. have an effective, independent internal auditand compliance program;

6. appropriately train and supervise the employ-ees conducting insurance and annuity salesactivities;

7. take reasonable precautions to ensure thatdisclosures to customers for insurance andannuity sales and solicitations are complete

and accurate and are in compliance withapplicable laws and regulations;

8. ensure compliance with all applicable fed-eral, state, or other jurisdiction regulations,including compliance with sections 23A and23B of the Federal Reserve Act as that actapplies to affiliate transactions; and

9. have controls in place to ensure accurate andtimely financial reporting.

Every banking organization conducting insur-ance or annuity sales activities should haveappropriate, board-approved policies, proce-dures, and controls in place to monitor andensure that it complies with both federal andstate regulatory requirements. Consistent withthe principle of functional regulation, the Fed-eral Reserve will rely primarily on the appropri-ate state insurance authorities to monitor andenforce compliance with applicable state insur-ance laws and regulations, including state con-sumer protection laws and regulations govern-ing insurance sales.

3950.0.4.1.1 Sales Practices andHandling of Customer Complaints

Every component of a banking organization thatengages in insurance or annuity sales activitiesshould have board-approved policies and proce-dures for handling customer complaints relatedto these sales. The customer complaint processshould provide for the recording and tracking ofall complaints and require periodic reviews ofcomplaints by compliance personnel. A BHC’sor state member bank’s board of directors andsenior management should also review com-plaints if the complaints involve significantcompliance issues that may pose a risk to theorganization.

3950.0.4.1.2 Third-Party Arrangements

BHCs and state member banks, to the extentpermitted by applicable law, may enter intoagreements with third parties, including unaffili-ated agents or agencies, to sell insurance orannuities or provide expertise and services thatotherwise would have to be developed in-house.Many banks hire third parties to assist in estab-lishing an insurance program or to train theirown insurance staff. A bank may also find itadvantageous to offer more specialized insur-ance products through a third-party arrangement.

A BHC’s or state member bank’s manage-ment should conduct a comprehensive review ofan unaffiliated third party before entering into

10. See section 3500.0.



any arrangement to conduct insurance or annu-ity sales with the third party. The review shouldinclude an assessment of the third party’s finan-cial condition, management experience, reputa-tion, and ability to fulfill its contractual obliga-tions to the BHC or state member bank, whichincludes compliance with applicable consumerprotection laws and regulations.

The BHC’s or state member bank’s board ofdirectors or its designated committee shouldapprove any agreements with third parties. Agree-ments should outline the duties and responsibili-ties of each party; describe the third-partyactivities permitted on the institution’s prem-ises; address the sharing or use of confidentialcustomer information; and define the terms foruse of the BHC’s or state member bank’s officespace, equipment, and personnel. If an arrange-ment includes dual employees (for example,bank employees who are also employed by anindependent third party), the agreement mustprovide for written employment contracts thatspecify the duties of these employees and theircompensation arrangements.

In addition, a third-party agreement shouldspecify that the third party will comply with allapplicable laws and regulations and will con-duct its activities in a manner consistent withthe CPSI regulation, if applicable. The agree-ment should authorize the banking organizationto monitor the third party’s compliance with itsagreement, as well as authorize the bankingorganization to have access to third-party recordsconsidered necessary to evaluate compliance. ABHC or state member bank that contracts with afunctionally regulated third party should obtainfrom and review, as appropriate, any relevant,publicly available regulatory reports of exami-nation of the third party.11 Finally, the agree-ment should provide for indemnification of theinstitution by the unaffiliated third party for anylosses caused by the conduct of the third party’semployees in connection with its salesactivities.

A BHC or state member bank is responsiblefor ensuring that any third party or dual employeeselling insurance at or on behalf of the organiza-tion is appropriately trained either by the bank-ing organization or the third party with respectto compliance with the minimum disclosuresand other requirements of the CPSI regulationand applicable state regulations. The bankingorganization should obtain and review copies ofthird-party training and compliance materials

to monitor the third party’s performance on itsdisclosure and training obligations.

3950.0.4.1.3 Designation, Training, andSupervision of Personnel

A banking organization hiring personnel to sellinsurance or annuities should investigate thebackgrounds of the prospective employees. Whena candidate for employment has previous insur-ance industry experience, the banking organiza-tion should have procedures to determine whetherthe individual has been the subject of any disci-plinary actions by state insurance regulators.12

The banking organization should require itsown insurance or annuity sales personnel orthird-party sales personnel selling at or on behalfof the bank to receive appropriate training andlicensing. Training should cover appropriatepolicies and procedures for the organization’ssales of insurance and annuity products. Person-nel who are referring potential or establishedcustomers to a licensed insurance producer shouldalso be trained to ensure that referrals are madein conformance with the CPSI regulation, ifapplicable. The training should also include pro-cedures and guidance to ensure that an unli-censed or referring individual cannot be deemedto be acting as an insurance agent that is subjectto licensing requirements.

When insurance or annuities are sold by abanking organization or by third parties at anoffice of, or on behalf of, the organization, theinstitution should have policies and proceduresto designate, by title or name, the individualsresponsible for supervising insurance salesactivities, as well as for supervising the referralactivities of bank employees not authorized tosell these products. A banking organization alsoshould designate supervisory personnel respon-sible for monitoring compliance with any third-party agreement, as well as a state memberbank’s compliance with the CPSI regulation, ifapplicable.

3950.0.4.1.4 Compliance

Banking organizations should have policies andprocedures to ensure that insurance or annuity

11. The reports of examination issued by state insuranceregulators are generally public documents. Many states do notconduct periodic examinations of insurance sales activities.

12. Information from the states on the issuance and termi-nation of producer licenses and on producers’ compliancewith continuing education requirements is available from theNAIC database known as the National Insurance ProducerRegistry (NIPR).



sales activities are conducted in compliance withapplicable laws and regulations (including theCPSI regulation for sales conducted by or onbehalf of a state member bank) and the institu-tion’s internal policies and procedures. Compli-ance procedures should identify any potentialconflicts of interest and how such conflicts shouldbe addressed. For example, sales-compensationprograms should be conducted in a manner thatwould not expose the BHC or state memberbank to undue legal or reputation risks. Thecompliance procedures should also provide for asystem to monitor customer complaints andtheir resolution. Where applicable, complianceprocedures also should call for verification thatthird-party sales are being conducted in a man-ner consistent with the governing agreementwith the banking organization.

The compliance function should be conductedindependently of the insurance and annuity prod-uct sales and management activities. Compli-ance personnel should determine the scope andfrequency of their reviews, and findings of com-pliance reviews should be reported directly tothe banking organization’s board of directors orto its designated board committee.

3950.0.5 RISK ASSESSMENT OFINSURANCE AND ANNUITY SALESACTIVITIES

A risk assessment of insurance activities may beaccomplished (1) in the course of conducting aregularly scheduled BHC inspection or statemember bank examination or (2) as a targetedreview. The purpose of preparing the riskassessment is to determine the level and direc-tion of risk to the BHC or bank arising from itsinsurance and annuity sales activity. The risks tobanking organizations engaged in insurance salesprograms consist primarily of legal, reputa-tional, and operational risk, all of which maylead to financial loss. After completing the riskassessment, if material concerns remain, theBoard’s Division of Banking Supervision andRegulation staff should be consulted for furtherguidance.

Legal and reputational risk may arise from avariety of sources, such as fraud; noncompli-ance with statutory or regulatory requirements,including those pertaining to the handling ofpremiums collected on behalf of the under-writer; claims processing; insurance and annuitysales practices; and the handling of ‘‘errors and

omissions’’ claims.13 Other sources of legal andreputational risk may arise from failing to safe-guard nonpublic customer information; a highvolume of customer complaints; or public regu-latory sanctions against a producer.

Legal and reputational risks may also arisefrom an agent’s obligation to provide a cus-tomer with products that are suited to the cus-tomer’s particular needs and are priced and soldin accordance with state regulations. Addition-ally, an agent or agency may be liable for failingto carry out the appropriate paperwork to bind apolicy that it has sold to a customer, or formaking an error in binding the policy. Stateinsurance departments generally are permittedby law to suspend or revoke a producer’s licenseand assess monetary penalties against a pro-ducer if warranted.

Operational risk may arise from errors inprocessing sales-related information or fromlack of appropriate controls over systems orstaff responsible for carrying out the insuranceor annuity sales activities. Additionally, bankingorganizations that have recently commencedinsurance or annuity sales activities, or that areexpanding their insurance sales business, areexposed to risk arising from inadequate strategicand financial planning associated with theactivities, which could result in financial loss.Examiners should be attuned to risks that mayarise from inadequate controls over insuranceactivities, a rapid expansion of the insurance orannuity sales programs offered by banking orga-nizations, the introduction of new products ordelivery channels, and legal and regulatorydevelopments.

Operational risk may arise from inadequatepremium-payment procedures and trust-account-balance administration by an agency. When theinsurance agency bills the insured, the agentmust comply with requirements for forwardingthe payments to the insurer and for safekeepingthe funds. Inadequate internal controls over thisactivity may result in the inappropriate use ofthese funds by the agent or agency. The bankingorganization should ensure that appropriate con-trols are in place to verify that all funds that areowed to the insurer or the insured are identifiedin the trust account and that the account is inbalance.

When conducting a risk assessment, theexaminer should first obtain relevant informa-tion to determine the existence and scale of

13. Errors and omissions insurance indemnifies the insuredagainst loss sustained because of an error or oversight by theinsured. For instance, an insurance agency generally pur-chases this type of coverage to protect itself against suchthings as failing to issue a policy.



insurance or annuity sales activity. Such infor-mation is available in the BHC’s Bank HoldingCompany Performance Report or the state mem-ber bank’s Uniform Bank Performance Report(UBPR) and in other System reports on insur-ance activities. Relevant reports, including appli-cable balance sheets and income statements forthe insurance and annuity sales activities, mayalso be obtained from the BHC or state memberbank. When preparing a risk assessment for aninsurance or annuity sales activity that is con-ducted by a functionally regulated nonbank sub-sidiary of a BHC or state member bank, examin-ers should rely, to the fullest extent possible, oninformation available from the BHC or statemember bank and the appropriate state insur-ance regulator for the subsidiary. If informationthat is needed to assess the risk cannot beobtained from the BHC or state member bank,or from the applicable functional regulator, theexaminer should consult with the appropriatedesignated Board staff. Requests should not bemade directly to a functionally regulated non-bank insurance and annuity sales subsidiary of aBHC or state member bank without first obtain-ing approval from the appropriate Board staff.

3950.0.6 CONSUMER PROTECTIONIN SALES OF INSURANCE RULES

3950.0.6.1 Overview of the CPSIRegulation

The CPSI regulation is only applicable to allinsured depository institutions, including statemember banks.14 The regulation, however, gen-erally does notapply to nonbank affiliates orsubsidiaries of a state member bank unless thecompany engages in the retail sale of insuranceproducts or annuities at an office of, or on behalfof, an insured depository institution. Interpreta-tions of the regulation, issued by the federalbanking agencies, are found in appendix A ofthis section. Federal Reserve examiners areresponsible for reviewing state member banks’compliance with the regulation. A BHC’s boardof directors and senior management are respon-sible for overseeing its depository institutionsubsidiaries’ compliance with the CPSIregulation.

The regulation applies to the retail sale ofinsurance products and annuities by banks or byany other person at an office of a bank, or acting

on behalf of a bank. For purposes of the CPSIregulation, ‘‘office’’ means the premises of thebank where retail deposits are accepted. Theregulation applies only to the retail sale of insur-ance or annuity products—that is, when theinsurance is sold or marketed to an individualprimarily for personal, family, or householdpurposes.

3950.0.6.2 Misrepresentations Prohibited

The regulation prohibits a bank or other coveredperson from engaging in any practice or usingany advertisement at any office of, or on behalfof, the bank or a subsidiary of the bank if thepractice or advertisement could mislead any per-son or otherwise cause a reasonable person toerroneously believe—

1. that the insurance product or annuity is backedby the federal government or the bank, or isinsured by the Federal Deposit InsuranceCorporation (FDIC);

2. that an insurance product or annuity does nothave investment risk, including the potentialthat principal may be lost and the productmay decline in value, when in fact the prod-uct or annuity does have such risks; or

3. in the case of a bank or subsidiary of thebank at which insurance products or annu-ities are sold or offered for sale, that (1) thebank may condition approval of an extensionof credit to a consumer by the bank or sub-sidiary on the purchase of an insurance prod-uct or annuity from the bank or a subsidiaryof the bank and (2) the consumer is not freeto purchase the insurance product or annuityfrom another source.

The regulation also incorporates the anti-tying provisions of section 106(b) of the BankHolding Company Act Amendments of 1970(12 U.S.C. 1972). Additionally, banks are pro-hibited from selling life or health insuranceproducts if the status of the applicant or insuredas a victim of domestic violence or as a providerof services to domestic violence victims is con-sidered as a factor in decision making on theproduct, except as expressly authorized by statelaw.

3950.0.6.3 Insurance Disclosures

The regulation also requires that a bank or aperson selling insurance at an office of, or on

14. The CPSI regulation applies to all federally insureddepository institutions, including all federally chartered U.S.branches and state-chartered insured U.S. branches of foreignbanking organizations.



behalf of, a bank make the following affirmativedisclosures (to the extent accurate), both orallyand in writing, before the completion of theinitial sale of an insurance product or an annuityto a consumer. However, sales by mail or, if theconsumer consents, via electronic media (suchas the Internet) do not require oral disclosure.

1. The insurance product or annuity is not adeposit or other obligation of, or guaranteedby, the bank or an affiliate of the bank.

2. The insurance product or annuity is not insuredby the FDIC or any other U.S. governmentagency, the bank, or (if applicable) an affili-ate of the bank.

3. The insurance product or annuity, if applica-ble, has investment risk, including the pos-sible loss of value.

For telephone sales, written disclosures mustbe mailed within three business days. The abovedisclosures must be included in advertisementsand promotional materials for insurance prod-ucts and annuities, unless the advertisements orpromotional materials are of a general natureand describe or list the nature of services orproducts offered by the bank. Disclosures mustbe conspicuous and readily understandable.

3950.0.6.4 Credit Disclosures

When an application for credit is made in con-nection with the solicitation, offer, or sale of aninsurance product or annuity, the consumer mustbe notified that the bank may not condition theextension of credit on either (1) the consumer’spurchase of an insurance product or annuityfrom the bank or any of its affiliates or (2) theconsumer’s agreement not to obtain, or a prohi-bition on the consumer from obtaining, an insur-ance product or annuity from an unaffiliatedentity. These disclosures must be made bothorally and in writing; however, applicationstaken by mail or, if the consumer consents, viaelectronic media do not require oral disclosure.For telephone applications, the written disclo-sure must be mailed within three business days.The disclosures must be conspicuous and readilyunderstandable.

3950.0.6.5 Consumer Acknowledgment

The bank must obtain written or electronicacknowledgments of the consumer’s receipt of

the disclosures described above at the time theyare made or at the completion of the initialpurchase. For telephone sales, the bank mustreceive an oral acknowledgment and make areasonable effort to obtain a subsequent writtenor electronic acknowledgment.

3950.0.6.6 Location

Insurance and annuity sales activities must takeplace, to the extent practicable, in an area physi-cally segregated from one where retail depositsare routinely accepted from the general public(such as teller windows). The bank must clearlyidentify and delineate areas where insurance andannuity sales activities occur.

3950.0.6.7 Referrals

Any person who accepts deposits from the pub-lic in an area where deposits are routinely acceptedmay refer a consumer to a qualified person whosells insurance products or annuities only if theperson making the referral receives no morethan a one-time, nominal fee of a fixed dollaramount for the referral. The amount of the refer-ral fee may not depend on whether a sale resultsfrom the referral.

3950.0.6.8 Qualifications

A bank may not permit any person to sell oroffer insurance products or annuities at its officeor on its behalf, unless that person is at all timesproperly qualified and licensed under applicablestate law for the specific products being sold orrecommended.

3950.0.6.9 Relationship of the CPSIRegulation to State Regulation

The GLB Act contains a legal framework fordetermining the effect of the CPSI regulation onstate laws governing the sale of insurance, includ-ing state consumer protection standards. In gen-eral, if a state has legal requirements that areinconsistent with, or contrary to, the CPSI regu-lation, initially the federal regulation does notapply in the state. However, the federal bankingagencies may, after consulting with the stateinvolved, decide to preempt any inconsistent orcontrary state laws if the agencies find that theCPSI regulation provides greater protectionsthan the state laws. It is not expected that therewill be significant conflict between state and



federal laws in this area. If the consumer protec-tion laws of a particular state appear to beinconsistent with and less stringent (that is, pro-vide less consumer protection) than the CPSIregulation, examiners should inform the staff ofthe Board’s Division of Banking Supervisionand Regulation.

3950.0.6.10 Relationship to FederalReserve Guidance on the Sale ofNondeposit Investment Products

When a bank sells insurance products or annu-ities that also are securities (such as variable lifeinsurance annuities), it must conform with theapplicable Federal Reserve and interagency guid-ance pertaining to a bank’s retail sales of nonde-posit investment products (NDIPs).15 If the CPSIregulation and the guidance pertaining to NDIPsconflict, the CPSI regulation prevails.

3950.0.6.11 Examining a State MemberBank for Compliance with the CPSIRegulation

Examinations for compliance with the CPSIregulation should be conducted consistent withthe risk-focused supervisory approach when astate member bank sells insurance products orannuities directly, or when a third party sellsinsurance or annuities at or on behalf of a statemember bank. To the extent practicable, theexaminer should conduct the review at the statemember bank. In certain instances, however, theexaminer’s review at the state member bankmay identify potential supervisory concerns aboutthe state member bank’s compliance with theCPSI regulation as it pertains to insurance orannuities sales conducted by a functionally regu-lated nonbank affiliate or subsidiary of the statemember bank that is selling insurance productsor annuities at or on behalf of the state memberbank.

If the examiner determines that an on-sitereview of a functionally regulated nonbankaffiliate or subsidiary of the state member bankis appropriate to adequately assess the statemember bank’s compliance with the CPSI regu-lation, the examiner should discuss the situationwith staff of the Board’s Division of BankingSupervision and Regulation. The approval ofthe Division of Banking Supervision and Regu-lation’s officer that is responsible for the super-visory policy and examination guidance pertain-

ing to insurance and annuity sales activitiesshould be obtained before examining or request-ing any information directly from a functionallyregulated nonbank affiliate or subsidiary of thestate member bank that is selling insurance orannuity products at or on behalf of the statemember bank.

The state member bank examination proce-dures described in section 3950.0.10.2 apply toretail sales, solicitations, advertisements, or offersof insurance products and annuities by any statemember bank or any other person that is engagedin such activities at an office of the bank, or onbehalf of the state member bank. For purposesof the CPSI regulation, activities ‘‘on behalf of astate member bank’’ include activities in whicha person, whether at an office of the bank or atanother location, sells, solicits, advertises, oroffers an insurance product or annuity and inwhich at least one of the following applies:

1. The person represents to a consumer that thesale, solicitation, advertisement, or offer ofany insurance product or annuity is by or onbehalf of the bank.

2. The bank refers a consumer to a seller ofinsurance products or annuities, and the bankhas a contractual arrangement to receive com-missions or fees derived from the sale of aninsurance product or annuity resulting fromthe bank’s referral.

3. Documents evidencing the sale, solicitation,advertising, or offer of an insurance productor annuity identify or refer to the bank.

3950.0.7 APPENDIX A—JOINTINTERPRETATIONS OF THECONSUMER PROTECTION IN SALESOF INSURANCE REGULATION

In response to a banking association’s inquiries,the federal banking agencies jointly issued inter-pretations regarding the Consumer Protection inSales of Insurance (CPSI) regulation.16 A jointstatement, issued on August 17, 2001, containsresponses to a set of questions relating to disclo-sure and acknowledgment, the scope of applica-bility of the regulation, and compliance. Addi-tionally, a February 28, 2003, joint statement

15. Interagency Statement on Retail Sales of NondepositInvestment Products, February 17, 1994. See SR-94-11.

16. These letters, issued jointly by the Board of Governorsof the Federal Reserve System, the Office of the Comptrollerof the Currency, the Federal Deposit Insurance Corporation,and the Office of Thrift Supervision, may be accessed on theseagencies’ web sites.



responded to a request to clarify whether thedisclosure requirements apply to renewals ofpre-existing insurance policies sold before Octo-ber 1, 2001, the effective date of the regulation.The issues raised and the banking agencies’responses are summarized below.

3950.0.7.1 Disclosures

3950.0.7.1.1 Credit Disclosures

A bank or other person who engages in insur-ance sales activities at an office of, or on behalfof, a bank (‘‘a covered person’’) must make thecredit disclosures set forth in the regulation if aconsumer is solicited to purchase insurance whilethe consumer’s loan application is pending. Aconsumer’s application for credit is still ‘‘pend-ing’’ for purposes of the regulation if the deposi-tory institution has approved the consumer’sloan application but not yet notified the con-sumer. Until the consumer is notified of the loanapproval, the covered person must provide thecredit disclosures if the consumer is solicited,offered, or sold insurance.

3950.0.7.1.2 Disclosures for Sales byMail and Telephone

The regulation requires a covered person toprovide oral disclosures and to obtain an oralacknowledgment of these disclosures when salesactivities are conducted by telephone. Thisrequirement applies regardless of whether theconsumer will also receive and acknowledgewritten disclosures in person, through the mail,or electronically.

3950.0.7.1.3 Use of Short-FormInsurance Disclosures

There is no short form for the credit disclosures.A depository institution, however, may use theshort-form insurance disclosures set forth belowin visual media (such as television broadcasting,ATM screens, billboards, signs, posters, andwritten advertisements and promotionalmaterials):

• NOT A DEPOSIT• NOT FDIC-INSURED• NOT INSURED BY ANY FEDERAL GOV-

ERNMENT AGENCY

• NOT GUARANTEED BY THE BANK• MAY GO DOWN IN VALUE

3950.0.7.2. Acknowledgment ofDisclosures

3950.0.7.2.1 Reasonable Efforts toObtain Written Acknowledgment

The banking agencies have not prescribed anysteps that must be taken for a depository institu-tion’s efforts to obtain a written acknowledg-ment to be deemed ‘‘reasonable’’ in a transac-tion conducted by telephone. Examples ofreasonable efforts, however, include:

1. providing the consumer with a return-addressed envelope or similar means to fa-cilitate the consumer’s return of the writtenacknowledgment,

2. making a follow-up phone call or contact,3. sending a second mailing, or4. similar actions.

The covered person should (1) maintain docu-mentation that the written disclosures and therequest for written acknowledgment of thosedisclosures were mailed to the consumer and(2) record his or her efforts to obtain the signedacknowledgment. The ‘‘reasonable efforts’’ pol-icy exception for telephone sales does not applyto other types of transactions, such as mailsolicitations, in which a covered person mustobtain from the consumer a written (in elec-tronic or paper form) acknowledgment.

3950.0.7.2.2 Appropriate Form orFormat for Acknowledgment ProvidedElectronically

Electronic acknowledgments are not required tobe in a specific format but must be consistentwith the provisions of the CPSI regulation appli-cable to acknowledgments. That is, the elec-tronic acknowledgment must establish that theconsumer has acknowledged receipt of the creditand insurance disclosures, as applicable.

3950.0.7.2.3 Retention ofAcknowledgments by an InsuranceCompany

If an insurance company provides the disclo-sures and obtains the acknowledgment on behalfof a depository institution, the insurance com-



panymayretain theacknowledgment.Thedeposi-tory institution is responsible for ensuring thatsales made ‘‘on behalf of’’ the depository insti-tution are in compliance with the CPSI regula-tion. An insurance company may maintain docu-mentation showing compliance with the CPSIregulation, but the depository institution shouldhave access to such records and the recordsshould be readily available for review byexaminers.

3950.0.7.2.4 Form of WrittenAcknowledgment

There is no prescribed form for the writtenacknowledgment. The regulation requires, how-ever, that a covered person obtain the consum-er’s acknowledgment of receipt of the completeinsurance and credit disclosures.

3950.0.7.2.5 Timing of AcknowledgmentReceipt

A covered person must obtain the consumer’sacknowledgment either at the time a consumerreceives disclosures or at the time of the initialpurchase of an insurance product. The CPSIregulation does not prescribe any specific word-ing for an oral acknowledgment. However, if acovered person has made the insurance andcredit disclosures orally, an affirmative responseto the question ‘‘Do you acknowledge that youreceived this disclosure?’’ is acceptable.

3950.0.7.3 Scope of the CPSI Regulation

3950.0.7.3.1 Applicability to PrivateMortgage Insurance

Depending on the nature of a depository institu-tion’s involvement in an insurance sales transac-tion, the CPSI regulation may cover sales ofprivate mortgage insurance. If the depositoryinstitution itself purchases the insurance to pro-tect its interest in mortgage loans it has issuedand merely passes the costs of the insurance onto the mortgage borrowers, then the transactionis not covered by the regulation. If, however, aconsumer has the option of purchasing the pri-vate mortgage insurance and (1) the depositoryinstitution offers the private mortgage insuranceto a consumer or (2) any other person offers theprivate mortgage insurance to a consumer at anoffice of a depository institution, or on behalf ofa depository institution, the transaction wouldbe covered by the regulation.

3950.0.7.3.2 Applicability to FederalCrop Insurance

The CPSI regulation does not apply to federalcrop insurance that is sold for commercial orbusiness purposes. However, if the crop insur-ance is purchased by an individual primarily forfamily, personal, or household purposes, it wouldbe covered.

3950.0.7.3.3 Solicitations andApplications Distributed Before, butReturned After, the Effective Date of theCPSI Regulation

Direct-mail solicitations and ‘‘take-one’’ appli-cations that are distributed on or after October 1,2001, must comply with the CPSI regulation. Ifa consumer seeks to purchase insurance afterthe effective date of the regulation in responseto a solicitation or advertisement that was dis-tributed beforethat date, the depository institu-tion would be in compliance with the regulationif the institution provides the consumer, beforethe initial sale, with the disclosures required bythe regulation. These disclosures must be bothwritten and oral, except that oral disclosures arenot required if the consumer mails in theapplication.

3950.0.7.4 Renewals of Insurance

Renewals of insurance are not subject to thedisclosure requirements (see the 3950.0.7.1 sec-tions above), but are subject to other require-ments of the CPSI regulation. A ‘‘renewal’’ ofinsurance means continuation of coverageinvolving the same type of insurance for a con-sumer as issued by the same carrier. A renewalneed not be on the same terms and conditions asthe original policy, provided that the renewaldoes not involve a different type of insuranceand the consumer has previously received thedisclosures required by the regulation at thetime of the initial sale. An upgrade in coverageat a time when a policy is not up for renewalwould be treated as a renewal, provided that thesolicitation and sale of the upgrade do notinvolve a different type of insurance and theconsumer has previously received the disclo-sures required by the regulation at the initialsale.



3950.0.7.4.1 Disclosures Required withRenewals of Insurance Coverage

The banking agencies’ interpretations clarifiedthat the CPSI regulation does not mandatedis-closures for renewals of policies sold beforeOctober 1, 2001. Accordingly, the CPSI regula-tion does not require the disclosures to be fur-nished at the time of renewal of a policy, includ-ing a pre-existing policy. However, renewals aresubject to the other provisions of the CPSI regu-lation. Moreover, the banking agencies wouldexpect that, consistent with applicable safety-and-soundness requirements, depository institu-tions would take reasonable steps to avoid cus-tomer confusion in connection with renewals ofpre-existing policies.

3950.0.7.4.2 ‘‘On-Behalf-of’’ Test andUse of Corporate Name or Logo

Under the CPSI regulation, an affiliate of a bankis not considered to be acting ‘‘on behalf of’’ abank simply because the affiliate’s marketing orother materials use a corporate name or logothat is common to the bank and the affiliate. Ingeneral, this exclusion applies even if a bankand its parent holding company have a similar,but not identical, name. For example, if thenames of all of the affiliates of a bank holdingcompany share the words ‘‘First National,’’ anaffiliate would not be considered to be engagedin an activity ‘‘on behalf of’’ an affiliated banksimply by using the terms ‘‘First National’’ aspart of a corporate logo or identity. The affiliatewould, however, be considered to be acting ‘‘onbehalf of’’ an affiliated bank if the name of thebank (for example, ‘‘First National Bank’’)appears in a document as the seller, solicitor,advertiser, or offeror of insurance. A transactionalso would be covered if it occurs on the prem-ises of a depository institution or if one of theother prongs of the ‘‘on-behalf-of’’ test is met.

3950.0.7.5 Compliance

3950.0.7.5.1 Appropriate Documentationof an Oral Disclosure or OralAcknowledgment

There is no specific documentation requirementfor oral disclosures or acknowledgments. How-ever, other applicable regulatory reporting stan-

dards would apply. Appropriate documentationof an oral disclosure would clearly show that thecovered person made the credit and insurancedisclosures to a consumer. Similarly, appropri-ate documentation of an oral acknowledgmentwould clearly show that the consumer acknowl-edged receiving the credit and insurance disclo-sures. For example, a tape recording of theconversation (where permitted by applicablelaws) in which the covered person made the oraldisclosures and received the oral acknowledg-ment would be acceptable. Another examplewould be a contemporaneous checklist com-pleted by the covered person to indicate that heor she made the oral disclosures and receivedthe oral acknowledgment. A contemporaneousnote to the consumer’s file would also be adequate.The documentation should be maintained in theconsumer’s file so that it is accessible toexaminers.

3950.0.7.5.2 Setting for Insurance Sales

A depository institution must identify the areaswhere insurance sales occur and must clearlydelineate and distinguish those areas from areaswhere the depository institution’s retail deposit-taking activities occur. Although the bankingagencies did not define how depository institu-tions could ‘‘clearly delineate and distinguish’’insurance areas, signage or other means may beused.

3950.0.8 APPENDIX B—GLOSSARY

See section 4040.1 of theCommercial BankExamination Manual for additional definitionsof insurance terms.

Accident and health insurance.A type of cover-age that pays benefits in case of sickness, acci-dental injury, or accidental death. This coveragemay provide for loss of income when the insuredbecomes disabled and provides reimbursementfor medical expenses when the insured is ill.The insurance can provide for debt payment if itis taken out in conjunction with a loan. (SeeCredit life insurance.)

Actuary. A professional whose function is tocalculate statistically various estimates for thefield of insurance, including the estimated riskof loss on an insurable interest and the appropri-ate level for premiums and reserves.

Admitted insurer.An insurance company licensed



by a state insurance department to underwriteinsurance products in that state.

Agency contract (or agreement). An agreementthat establishes the contractual relationshipbetween an agent and an insurer.

Agent. A licensed insurance company represen-tative under contract to one or more insurancecompanies. Depending on the line of insurancerepresented, an agent’s power may includesoliciting, advertising, and selling insurance;collecting premiums; claims processing; andeffecting insurance coverage on behalf of aninsurance underwriter. Agents are generally com-pensated by commissions on policies sold,although some may receive salaries.

1. Captive or exclusive agent. An agent whorepresents a single insurer.

2. General agents. An agent who is contractu-ally awarded a specific geographic territoryfor an individual insurance company. Gen-eral agents are responsible for building theirown agency and usually represent only oneinsurer. Unlike exclusive agents, who usuallyreceive a salary in addition to commissions,general agents are typically compensated ona commission basis only.

3. Independent agent. An agent who is undercontractual agreements with at least two dif-ferent insurers. Typically, all of the indepen-dent’s agent’s compensation originates fromcommissions.

Aggregate excess-of-loss reinsurance. A form of‘‘excess-of-loss’’ reinsurance that indemnifiesthe ceding company against the amount bywhich all of the ceding company’s losses incurredduring a specific period (usually 12 months)exceed either (1) a predetermined dollar amountor (2) a percentage of the company’s subjectpremiums. This type of contract is also com-monly referred to as stop-loss reinsurance orexcess-of-loss ratio reinsurance.

Allied lines. Various insurance coverages foradditional types of losses and against losses byadditional perils. The coverages are closelyassociated with and usually sold with fire insur-ance. Examples include coverage against lossby perils other than fire, coverage for sprinkler-leakage damage, and business-interruptioncoverage.

Annuity. A contract that provides for a series ofpayments payable over an individual’s life spanor other term, on the basis of an initial lump-

sum contribution or series of payments made bythe annuitant into the annuity during the accu-mulation phase of the contract.

1. Fixed-annuity contracts provide for pay-ments to annuitants at fixed, guaranteed mini-mum rates of interests.

2. Variable-annuity contracts provide for pay-ments based on the performance of annuityinvestments. Variable-annuity contracts areusually sold based on a series of paymentsand offer a range of investment or fundingoptions such as stocks, bonds, and moneymarket fund investments. The annuity princi-pal and the investment return are not guaran-teed as they depend on the performance ofthe underlying funding option.

Annuity payments may commence with the ex-ecution of the annuity contract (immediate an-nuity) or may be deferred until some future date(deferred annuity).

Assigned risk. A risk that is not usually accept-able to insurers and is therefore assigned to agroup of insurers who are required to share inthe premium income and losses, in accordancewith state requirements, in order for the insurerto sell insurance in the state.

Assignment. The legal transfer of one person’sinterest in an insurance policy to another personor business.

Bank-owned life insurance (BOLI). Life insur-ance purchased and owned by a BHC or bank tofund its exposure arising from employee com-pensation and benefit programs. In a typicalBOLI program, a BHC or bank insures a groupof employees; pays the life insurance policypremiums; owns the cash values of the policies,which are booked on the BHC’s or bank’s bal-ance sheet as ‘‘other assets’’; and is the benefi-ciary of the policies upon the death of anyinsured employee or former employee.

Beneficiary. The person or entity named in aninsurance policy as the recipient of insuranceproceeds upon the policyholder’s death or whenan endorsement matures. A revocable benefi-ciary can be changed by the policyholder at anytime. An irrevocable beneficiary can be changedby the policyholder only with the written per-mission of the beneficiary.

Binder. A written or oral agreement, typically



issued by an insurer, agent, or broker for prop-erty and casualty insurance, to indicate accep-tance of a person’s application for insurance andto provide interim coverage pending the insur-ance company’s issuance of a binding policy.

Blanket bond. Coverage for an employer forloss incurred as a result of employee dishonesty.

Boiler and machinery insurance. Insuranceagainst the sudden and accidental breakdown ofboilers, machinery, and electrical equipment,including coverage for damage to the equipmentand property damage, including the property ofothers. Coverage can be extended to cover con-sequential losses, including loss from interrup-tion of business.

Broker. A person who represents the insurancebuyer in the purchase of insurance. Brokers donot have the power to bind an insurance com-pany to an insurance contract. Once a contract isaccepted, the broker is compensated for thetransaction through a commission from theinsurance company. An individual may belicensed as both a broker and an agent.

Bulk reinsurance. A transaction sometimesdefined by statute as any quota-share, surplusaid, or portfolio reinsurance agreement throughwhich an insurer assumes all or a substantialportion of the liability of the reinsured company.

Captive insurer. An insurance company estab-lished by a parent firm to insure or reinsure itsown risks or the risks of affiliated companies. Acaptive may also underwrite insurable risks ofunaffiliated companies, typically the risks of itscustomers or employees. For example, a BHCor bank may form a captive insurance companyto underwrite its own directors’ and officers’risks or to underwrite credit life or private mort-gage insurance (third-party risks) related to itslending activities.

Cash surrender value of life insurance. Theamount of cash available to a life insurancepolicyholder upon the voluntary termination ofa life insurance policy before it becomes pay-able by death or maturity.

Casualty insurance. Coverage for the liabilityarising from third-party claims against the insuredfor negligent acts or omissions causing bodilyinjury or property damage.

Cede. To transfer to a reinsurer all or part of theinsurance or reinsurance risk underwritten by aninsurance company.

Ceding commission. The fee paid to a reinsur-ance company for assuming the risk of a pri-mary insurance company.

Ceding company (also cedant, reinsured, reas-sured). The insurer that transfers all or part ofthe insurance or reinsurance risk it has under-written to another insurer or reinsurer via areinsurance agreement.

Cession. The amount of insurance risk trans-ferred to the reinsurer by the ceding company.

Churning. The illegal practice wherein a cus-tomer is persuaded to unnecessarily cancel oneinsurance policy in favor of buying a purport-edly superior policy, often using the cash surren-der value of the existing policy to pay the earlypremiums of the new policy. In such a transac-tion, the salesperson benefits from the additionalcommission awarded for booking a new policy.

Claim. A request for payment of a loss underthe terms of a policy. Claims are payable in themanner suited to the insured risk. Life, property,casualty, health, and liability claims generallyare paid in a lump sum after the loss is incurred.Disability and loss-of-time claims are paid peri-odically during the period of disability or througha discounted lump-sum payment.

Coinsurance. A provision in property and casu-alty insurance that requires the insured to main-tain a specified amount of insurance based onthe value of the property insured. Coinsuranceclauses are also found in health insurance andrequire the insured to share a percentage of theloss.

Combination-plan reinsurance. A reinsuranceagreement that combines the excess-of-loss andthe quota-share forms of coverage within onecontract, with the reinsurance premium estab-lished as a fixed percentage of the ceding com-pany’s subject premium. After deducting theexcess recovery on any one loss for one risk, thereinsurer indemnifies the ceding company onthe basis of a fixed quota-share percentage. If aloss does not exceed the excess-of-loss retentionlevel, only the quota-share coverage applies.

Commission. The remuneration paid by insur-ance carriers to insurance agents and brokers forthe sale of insurance and annuity products.



Comprehensive personal liability insurance. Atype of insurance that reimburses the policy-holder if he or she becomes liable to pay moneyfor damage or injury he or she has caused toothers. This coverage does not include automo-bile liability but does include almost everyactivity of the policyholder, except businessoperations.

Contractholder. The person, entity, or group towhom an annuity is issued.

Credit for reinsurance. A statutory accountingprocedure, set forth under state insurance regu-lations, that permits a ceding company to treatamounts due from reinsurers as assets, or asoffsets to liabilities, on the basis of the reinsur-er’s status.

Credit life insurance. A term insurance productissued on the life of a debtor that is tied torepayment of a specific loan or indebtedness.Proceeds of a credit life insurance policy areused to extinguish remaining indebtedness atthe time of the borrower’s death. The term isapplied broadly to other forms of credit-relatedinsurance that provide for debt satisfaction inthe event of a borrower’s disability, accident orillness, and unemployment. Credit life insurancehas historically been among the most commonBHC and bank insurance products.

Credit score. A number that is based on ananalysis of an individual’s credit history andthat insurers may consider as an indicator of riskfor purposes of underwriting insurance. Wherenot prohibited by state law, insurers may con-sider a person’s credit history when underwrit-ing personal lines.

Debt-cancellation contract/debt-suspensionagreement. A loan term or contract between alender and borrower whereby, for a fee, thelender agrees to cancel or suspend payment onthe borrower’s loan in the event of the borrow-er’s death, serious injury, unemployment, orother specified events. The Office of the Comp-troller of the Currency considers these productsto be banking products. State law determineswhether these products are bank or insuranceproducts for state-chartered banks and insurancecompanies.

Deductible. The amount a policyholder agreesto pay toward the total amount of insurance loss.The deductible may apply to each claim for aloss occurrence, such as each automobile acci-

dent, or to all claims made during a specifiedperiod, as with health insurance.

Directors’ and officers’ liability insurance. Lia-bility insurance covering a corporation’s obliga-tion to reimburse its directors or officers forclaims made against them for alleged wrongfulacts. It also provides direct coverage for com-pany directors and officers themselves in instanceswhen corporate indemnification is not available.

Direct premiums written. Premiums received byan underwriter for all policies written during agiven time period by the insurer, excluding thosereceived through reinsurance assumed.

Direct writer. An insurance company that dealsdirectly with the insured through a salaried rep-resentative, as opposed to those insurers that useagents. This term refers to insurers that operatethrough exclusive agents. In reinsurance, a directwriter is the company that originally under-writes the insurance policies ceded.

Disability income insurance. An insurance prod-uct that provides income payment to the insuredwhen his or her income is interrupted or termi-nated because of illness or accident.

Endowment insurance. A type of life insurancecontract under which the insured receives theface value of the policy if he or she survives theendowment period. Otherwise, the beneficiaryreceives the face value of the policy upon thedeath of the insured.

Errors and omissions (E&O) liability insurance.Professional liability insurance that coversnegligent acts or omissions resulting in loss.Insurance agents are continually exposed to theclaim that inadequate or inappropriate coveragewas recommended resulting in a lack of cover-age for losses incurred. The agent or the carriermay be responsible for coverage for legitimateclaims.

Excess-of-loss reinsurance. A form of reinsur-ance whereby an insurer pays the amount ofeach claim for each risk up to a limit determinedin advance, and the reinsurer pays the amount ofthe claim above that limit up to a specific sum.It includes various types of reinsurance, such ascatastrophe reinsurance, per-risk reinsurance,per-occurrence reinsurance, and aggregateexcess-of-loss reinsurance.



Excess-per-risk reinsurance. A form of excess-of-loss reinsurance that, subject to a specifiedlimit, indemnifies the ceding company againstthe amount of loss in excess of a specifiedretention for each risk involved in eachoccurrence.

Excess and surplus lines. Property/casualty cov-erage that is unavailable from insurers licensedby the state (admitted insurers) and must bepurchased from a nonadmitted underwriter.

Exposure. The aggregate of all policyholder lim-its of liability arising from policies written.

Face amount. The amount stated on the face ofthe insurance policy to be paid, depending onthe type of coverage, upon death or maturity. Itdoes not include dividend additions or addi-tional amounts payable under accidental deathor other special provisions.

Facultative reinsurance. Reinsurance of indi-vidual risks by offer and acceptance wherein thereinsurer retains the faculty to accept or rejecteach risk offered by the ceding company.

Financial guarantee insurance. Financial guar-antee insurance is provided for a wide array offinancial risks. Typically, coverage is providedfor the fulfillment of a specific financial obliga-tion originated in a business transaction. Theinsurer, in effect, is lending the debtor its owncredit rating to enhance the debtor’screditworthiness.

Financial strength rating. Opinion as to aninsurance company’s ability to meet its seniorpolicyholder obligations and claims. For manyyears, the principal rating agency for propertyand casualty insurers and life insurers has beenA.M. Best. Other rating agencies, such as Fitch,Moody’s, Standard and Poor’s, and Weiss, alsorate insurers.

Fixed annuity. See annuity.

Flood insurance. A special insurance policy toprotect against the risk of loss or damage toproperty caused by flooding. Regular homeown-ers’ policies do not pay for damages caused byflooding.

General liability insurance. A broad commer-cial policy that covers all business liabilityexposures, such as product liability, completed

operations, premises and operations, indepen-dent contractors, and other exposures that arenot specifically excluded.

Gross premiums written. Total premiums forinsurance written during a given period, beforededuction for reinsurance ceded.

Group insurance. Insurance coverage typicallyissued to an employer under a master policy forthe benefit of employees. The insurer usuallydoes not condition coverage of the people thatmake up the group upon satisfactory medicalexaminations or other requirements. The indi-vidual members of the group hold certificates asevidence of their insurance.

Health insurance. An insurance product thatprovides benefits for medical expenses incurredas a result of sickness or accident. This productmay be in the form of traditional indemnityinsurance or managed-care plans and may beunderwritten on an individual or group basis.

Incurred but not reported (IBNR). The loss-reserve value established by insurance and rein-surance companies in recognition of their liabil-ity for future payments on losses that haveoccurred but have not yet been reported to them.This definition is often erroneously expanded toinclude adverse loss development on reportedclaims. The term incurred but not enough reported(IBNER) is being increasingly used to reflectmore accurately the adverse development oninadequately reserved reported claims.

Inland marine insurance. A broad field of insur-ance that covers cargo being shipped by air,truck, or rail. It includes coverage for mostproperty involved in transporting cargo as wellas for bridges, tunnels, and communicationssystems.

Keyperson life insurance.Life insurancedesignedto cover the key employees of an employer. Itmay be written on a group- or an individual-policy basis.

Lapse. The termination or discontinuance of apolicy resulting from the insured’s failure to paythe premium due.

Liability insurance. Protects policyholders fromfinancial loss due to liability resulting from inju-ries to other persons or damage to their property.

Lines. A term used in insurance to denote insur-ance business lines, as in ‘‘commercial lines’’and ‘‘personal lines.’’



Long-term care insurance. Health insurancedesigned to supplement the cost of nursinghome care or other care facilities in the event ofa long-term illness or permanent disability orincapacity.

Managing general agent. A managing generalagent (MGA) is a wholesaler of insurance prod-ucts and services to insurance agents. An MGAreceives contractual authority from an insurer toassume many of the insurance company’s func-tions. The MGA may provide insurance prod-ucts to the public through local insurance agentsas well as provide services to an insurance com-pany, including marketing, accounting, data pro-cessing, policy maintenance, and claims-monitoring and -processing services. Manyinsurance companies prefer the MGA distribu-tion and management system for their insuranceproducts because it avoids the high cost of es-tablishing branch offices. Most states requirethat an MGA be licensed.

Manuscript policy. A policy written to includespecific coverage or conditions not provided ina standard policy.

Morbidity. The incidence and severity of illnessand disease in a defined class of insured persons.

Mortality. The rate at which members of a groupdie in a specified period of time or die from aspecific illness.

Mortgage guarantee insurance. A product thatinsures lenders against nonpayment by borrow-ers. The policies are issued for a specified timeperiod. Lenders who finance more than 80 per-cent of the property’s fair value generally requiresuch insurance.

Mortgage insurance. Life insurance that paysthe balance of a mortgage even if the borrowerdies. Coverage typically is in the form of termlife insurance, with the coverage declining asthe debt is paid off.

Multiperil insurance. An insurance contract pro-viding coverage against many perils, usuallycombining liability and physical damagecoverage.

Net premiums written. The amount of grosspremiums written, after deduction for premiumsceded to reinsurers.

Ninety-day loss rule. A state requirement for aninsurer to establish a loss provision for reinsur-ance recoverables over 90 days past due.

Obligatory treaty. A reinsurance contract underwhich business must be ceded in accordancewith contract terms and must be accepted by thereinsurer.

Policyholder. The person or entity who owns aninsurance policy. This is usually the insuredperson, but it may also be a relative of theinsured, a partnership, or a corporation.

Premium. The payment, or one of the periodicpayments, a policyholder agrees to make forinsurance coverage.

Private mortgage insurance (PMI). Coveragefor a mortgage lender against losses due to acollateral shortfall on a defaulted residential realestate loan. Most BHCs and banks require bor-rowers to take out a PMI policy if a downpay-ment of less than 20 percent of a home’s valueis made at the time the loan is originated. PMIdoes not directly benefit a borrower, although itsexistence provides the opportunity to purchase ahome to many people who otherwise would notqualify for a loan.

Producer. A person licensed to sell, solicit, ornegotiate insurance.

Professional designations and organizations.Three of the most common insurance profes-sional designations are Chartered Life Under-writer (CLU), Chartered Property CasualtyUnderwriter (CPCU), and Chartered FinancialConsultant (ChFC). Insurance agents also joinprofessional organizations such as the AmericanSociety of Chartered Life Underwriters, theInternational Association of Financial Planning,the National Association of Life Underwriters,the National Association of Health Underwrit-ers, the American Council of Life Insurance, theLife Insurance Marketing and Research Asso-ciation, the Life Underwriter Training Council,and the Million Dollar Round Table.

Property insurance. Coverage for physical dam-age or destruction of real property (building,fixtures, and permanently attached equipment)and personal property (movable items that arenot attached to land) that occurs during thepolicy period as a result of, for example, fire,windstorm, explosion, and vandalism.

Pro rata reinsurance. A generic term describingall forms of ‘‘quota-share’’ and ‘‘surplus reinsur-



ance,’’ in which the reinsurer shares a pro rataportion of the losses and premiums of the ced-ing company.

Protected cell. A structure available to captiveinsurers underwriting risks of unaffiliated com-panies whereby the assets associated with theself-insurance program of one organization aresegregated to provide legal-recourse protectionfrom creditors of protected cells providing insur-ance coverage to other organizations.

Quota-share reinsurance. A form of pro ratareinsurance indemnifying the ceding companyfor a fixed percent of loss on each risk coveredin the contract in consideration of the samepercentage of the premium paid to the cedingcompany.

Rebating. Directly or indirectly giving or offer-ing to give any portion of the premium or anyother consideration to an insurance buyer as aninducement to purchase or renew the insurance.Rebates are forbidden under most state insur-ance codes.

Reinsurance. Insurance placed by an under-writer (the ceding company or reinsured) inanother company to transfer or reduce the amountof the risk assumed under the original insurancepolicy (or group of policies).

Reinsurance premium. The consideration paidby a ceding company to a reinsurer for thecoverage provided by the reinsurer.

Residual market. Also known as the shared mar-ket, it covers applications for insurance thatwere rejected by underwriters in the voluntarymarket that is covered by agency direct-marketing systems, perhaps because of high lossexperience by the insured party. The residualmarket includes government insurance pro-grams, specialty pools, and shared market mecha-nisms such as assigned-risk plans.

Retrocession. A reinsurance transaction wherebya reinsurer (the retrocedant) cedes all or part ofthe reinsurance risks it has assumed to anotherreinsurer (the retrocessionaire).

Retrospective rating. An insurance plan in whichthe current year’s premium is based on theinsured’s own loss experience for that sameperiod, subject to a maximum and minimum.

Rider. A written attachment, also known as anendorsement, to an insurance policy that changesthe original policy to meet specific require-ments, such as increasing or decreasing benefitsor providing coverage for specific property itemsbeyond that provided for under the insurancecompany’s standard contract terms.

Self-insured retention (SIR). The percentage of arisk or potential loss assumed by an insured,whether in the form of a deductible, self-insurance, or no insurance at all.

Separate accounts. Certain life insurance assetsand related liabilities that are segregated andmaintained to meet specific investment objec-tives of contract holders, particularly those assetsand liabilities associated with pension plans andvariable products offered by life insurers, whereinthe customer and not the insurer retains most ofthe investment and interest-rate risk.

Split-dollar life insurance. An arrangement thattypically involves an agreement between anemployer and an employee whereby the pre-mium payment, cash values, policy ownership,and death benefits may be split. There are manyvariations of split-dollar arrangements, includ-ing arrangements in which a trust is created tofacilitate estate planning. Split-dollar life insur-ance is designed to serve as a supplementalbenefit to a particular company executive. Thearrangement typically involves the payment ofthe insurance premium by the employer, withthe death benefit accruing to the employee.

Subrogation. An insurance carrier may reservethe ‘‘right of subrogation’’ in the event of a loss.This means that the company may choose totake action to recover the amount of a claimpaid to a covered insured if a third party causedthe loss. After expenses, the amount recoveredmust be divided proportionately with the insuredto cover any deductible for which the insuredwas responsible.

Term life insurance. An insurance product thatprovides, for a specified period of time, deathcoverage only. Typically, it has no savings com-ponent and, therefore, no cash value. Becauseterm insurance provides only mortality protec-tion, it generally provides the most coverage perpremium dollar. Most term life insurance poli-cies are renewable for one or more time periodsup to a stipulated maximum age; however, pre-miums generally increase with the age of thepolicyholder.



Title insurance. Insurance that protects BHCs,banks, and mortgagees against unknown encum-brances against real estate by indemnifying themortgagor and property owner in the event thatclear ownership of the property is clouded bythe discovery of faults in the title. Title insur-ance policies may be issued to either the mort-gagor or the mortgagee or both. Title insuranceis written largely only by companies specializ-ing in this class of insurance.

Treaty reinsurance. A reinsurance contract underwhich the reinsured company agrees to cede,and the reinsurer agrees to assume, risks of aparticular class or classes of business.

Twisting. In insurance, twisting involves makingmisrepresentations to a policyholder to inducethe policyholder to terminate one policy and totake out another policy with another company,when it is not to the insured’s benefit. Twistingis a violation of the Unfair Trade Practices Act.Twisting is similar to the ‘‘churning’’ concept insecurities sales, and it results in increased com-missions for the inducing agent.

Umbrella liability insurance. This type of liabil-ity insurance provides excess liability protectionover the ‘‘underlying’’ liability insurance cover-age to supplement underlying policies that havebeen reduced or exhausted by loss.

Underwriting. The process by which a companydetermines whether it can accept an applicationfor insurance and by which it may charge anappropriate premium for those applicationsselected. For example, the underwriting processfor life insurance classifies applicants by identi-fying such characteristics as age, sex, health,and occupation.

Unearned reinsurance premium. The part of thereinsurance premium that is applicable to theunexpired portion of the policies reinsured.

Universal life insurance. A form of permanentinsurance designed to provide flexibility in pre-mium payments and death benefit protection.The policyholder can pay maximum premiumsand maintain a high cash surrender value. Alter-natively, the policyholder can make minimalpayments in an amount only large enough tocover mortality and other expense charges.

Variable annuity. See Annuity.

Variable life insurance. A form of whole life, oruniversal life, insurance in which the policy-

holder’s cash value is invested in ‘‘separateaccounts’’ of the insurer. These accounts aresegregated from the insurance carrier’s otherasset holdings. Such separate account invest-ments are generally not available to a carrier’sgeneral creditors in the event of the carrier’sinsolvency. The policyholder assumes the invest-ment and price risk. Because variable life poli-cies have investment features, life insuranceagents selling these policies must be registeredrepresentatives of a broker-dealer licensed bythe National Association of Securities Dealersand registered with the Securities and ExchangeCommission.

Vendors’ single-interest insurance. A form offorce-placed insurance that is typically pur-chased by the BHC or bank to protect againstloss or damage to loan collateral in which theBHC or bank has a security interest. The bank-ing organization passes its expense for thisinsurance on to the consumer who has eitherrefused or is unable to obtain property insurance.

Viatical settlement. The cashing in of a lifeinsurance policy at a discount from face amountby policyholders who are often terminally illand need the money for medical care. The pur-chaser becomes the policyholder as well as thebeneficiary and assumes the premium paymentsof the policy.

Whole life insurance. A fixed-rate insuranceproduct, with premiums and death benefits guar-anteed over the duration of the policy. There is acash value (essentially a savings account) thataccrues to the policyholder tax deferred. A poli-cyholder receives the cash value in lieu of deathbenefits if the policy matures or lapses beforethe insured’s death. A policyholder also mayborrow against the policy’s accumulated cashvalue or use it to pay future premiums. For mostwhole life insurance policies, premiums are con-stant for the life of the insured’s contract.

3950.0.9 INSPECTION OBJECTIVES

1. To understand the volume and complexity ofthe banking organization’s insurance orannuity program and insurance sales strategy.

2. To assess the financial results of the activitycompared with planned results.

3. To determine if the insurance and annuitysales activities are effectively integrated into



the banking organization’s risk-management,audit, and compliance functions and if thecontrol environment is adequate.

4. To assess the adequacy of the banking orga-nization’s controls to ensure compliance withthe applicable state and federal laws andregulations.

5. To assess the level and direction of opera-tional, legal, and reputational risks to theconsolidated banking organization and thebank from the insurance or annuity salesactivity.

The following objectives apply if insurance prod-ucts or annuities are sold by another person atan office of, or on behalf of, a state memberbank subsidiary of the BHC.

6. To assess the adequacy of the BHC’s over-sight program for ensuring a state memberbank’s compliance with the Consumer Pro-tection in Sales of Insurance (CPSI) regula-tion. (See section 3950.0.1.)

7. To assess the effectiveness of the BHC’soversight of a state member bank’s compli-ance and audit programs with respect to theCPSI regulation.

8. To assess the BHC’s oversight of a statemember bank’s compliance with the CPSIregulation.

9. To obtain commitments for a BHC’s over-sight for needed corrective action when astate member bank is in violation of the CPSIregulation or when applicable policies, pro-cedures, practices, or management oversightto protect against violations is deficient.

3950.0.10 INSPECTION PROCEDURES

3950.0.10.1 Risk Assessment ofInsurance and Annuity Sales Activities

The examiner should consider the followingprocedures, as appropriate, when conducting arisk assessment to determine the level and direc-tion of risk exposure to the BHC that is attribut-able to insurance or annuity sales activity. Ifthere are specific areas of concern, the examinershould focus primarily on those areas.

1. Scope of activities and strategies. Assessthe significance and complexity of theinsurance or annuity sales program.a. Obtain a general overview of the scope

of the BHC’s insurance or annuity salesactivities and any anticipated or recentchange in or expansion of such activities.

b. Determine the BHC’s strategy for insur-ance or annuity sales, including strate-gies for cross-selling and referrals ofinsurance and banking products. Deter-mine the institution’s experience withany cross-marketing programs for bothinsurance business generated by the BHCand business generated by insuranceproducers.

c. Obtain two years’ worth of income state-ments, balance sheets, and budget docu-ments for the agency’s activities. Com-pare the expected budget items with theiractual results.

d. Determine the volume and type of insur-ance or annuity products and servicessold or solicited.

e. Determine what other related servicesthe BHC provides in connection with itsinsurance or annuity sales activities, suchas providing risk-management servicesto clients seeking advice on appropriateinsurance coverages, claims processing,and other activities.

f. If the BHC is not an FHC, confirm thatany insurance sales activities conductedby the BHC or a nonbank subsidiary arewithin the limited scope of activities per-missible for BHCs that are not FHCs.

2. Insurance sales products and concentrations.a. Determine the composition of sales—

• by line of business, such as property/casualty insurance, life insuranceincluding annuities, and healthinsurance;

• by the proportion of sales to commer-cial and retail customers; and

• by the portion of sales that is creditrelated, such as credit life and credithealth insurance.

b. Determine any sales concentrations toparticular entities, industries, or BHCcustomers.

c. Note any concentrations to large com-mercial accounts.

d. Determine what insurance services areprovided to the BHC, its employees, andBHC or bank affiliates.

3. Legal-entity and the risk-management struc-ture for insurance or annuity sales.a. Obtain an organizational chart for the

legal-entity and risk-management struc-ture for the insurance or annuity salesactivities.

b. Determine—



• whether the insurance or annuity salesactivity is conducted in an affiliatedproducer, by the BHC itself, throughanother distribution arrangement, or bya combination of these entities;

• the names of any affiliated insuranceagencies and the states where the affili-ated insurance agencies are licensed;and

• the locations outside of the UnitedStates where insurance or annuities aresold or solicited.

c. Determine if the insurance or annuityproducer is acting as a managing generalagent (MGA).17 If so, determine —• the scope of the MGA activities;• the BHC management’s assessment of

the risk associated with the MGAactivity; and

• what risk controls are in place to pro-tect the BHC from potential loss thatmay arise from the MGA’s activities,such as loss arising from legal liability.

4. Strategic and financial plans. Assess man-agement controls over the insurance annu-ity sales activities.a. Ascertain the BHC management’s strate-

gic and financial plans and goals for theinsurance or annuity sales activity.

b. Review the BHC’s due-diligence pro-cess for acquiring and pricing agencies,if applicable.

c. Review the BHC’s financial budgets andforecasts for the activity, particularly plansfor new products, marketing strategies,and marketing arrangements, and the rateof actual and expected growth for theactivity.

d. Determine the cause for significantdeviations from the plan.

e. Determine if any agency acquired by thestate member bank is providing theexpected return on investment and if theagency’s revenues are covering the debtservicing associated with the purchase, ifapplicable.

5. Review of board and committee records andreports.a. Review the reports of any significant

BHC oversight committees, includingrelevant board of directors’ and board

committees’ minutes and risk-management reports.

b. Determine if the BHC’s board of direc-tors, a board committee, or senior man-agement reviews reports pertaining toconsumer complaints and complaint reso-lution, information pertaining to litiga-tion and associated losses, and perfor-mance compared with the organization’splan for the insurance and annuity salesactivities.

6. Policies and procedures.a. Determine—

• the adequacy of the BHC’s policiesand procedures for conducting andmonitoring insurance or annuity salesactivities, including those policiesdesigned to ensure adherence with fed-eral and state laws and regulations per-taining to consumer protection;

• whether there are appropriate policiesand procedures for the handling of cus-tomer funds collected on behalf of theunderwriter; accurate and timely finan-cial reporting; complaint monitoringand resolution; effective system secu-rity and disaster-recovery plans; andpolicy-exception tracking and report-ing, and

• if the board of directors or a desig-nated committee of the board has for-mally approved the policies.

b. Obtain a detailed balance sheet for agencysubsidiaries, and determine if the assetsheld by insurance or annuity agency sub-sidiaries of BHCs and banks are all eli-gible investments.

c. Determine the independence of the BHC’saudit program applicable to the insur-ance and annuity sales activity. Ascer-tain if the audit program’s scope, fre-quency, and resources are commensuratewith the insurance and annuity activitiesconducted.

d. Determine how the BHC selects insur-ance underwriters with whom to dobusiness, as well as how the bankingorganization monitors the continuing per-formance of the underwriters.

e. Determine the adequacy of the BHCboard of directors’ oversight of the insur-ance management team’s qualifications,the training and licensing of personnel,and general compliance with state insur-ance regulations.

17. MGAs do not assume underwriting risk. Through con-tractual arrangements with an insurer, MGAs have the author-ity to write policies on behalf of the insurer in certaininstances, thereby binding the insurer to the policy. Certainminimum provisions governing MGA agreements are delin-eated in the applicable National Association of InsuranceCommissioners (NAIC) model law.



f. Review the internal controls of the BHCrelated to third-party arrangements,including arrangements for sales, pro-cessing, and auditing of insurance andannuity activities.

7. Claims, litigation, and functional regulatorsupervision. Assess legal and reputationalrisk.a. Identify any significant litigation against

the BHC arising from its insurance orannuity sales activity and the likely impactof the litigation on the BHC.

b. Obtain the insurance agency’s errors andomissions claims records for the pastseveral years, including a listing of claimsit has made and the amount of claims,the claim status, and the amount of claimpayments.

c. Review the BHC’s policies and proce-dures for tracking and resolving claims.Determine if the policies and proceduresappear adequate and if they are adheredto.

d. Determine if the applicable functionalregulator has any outstanding supervi-sory issues with the insurance agency.

8. Consumer complaints.a. Determine if the BHC’s management has

policies and procedures in place to assesswhether consumer complaints receivedare likely to expose the BHC to regula-tory action, litigation, reputational dam-age, or other significant risk.

b. Obtain applicable consumer complaintfiles, and evaluate internal control proce-dures to ensure the complaints are beingadequately addressed.

9. Audit and compliance functions.a. Determine the date of the most recent

review of the insurance or annuity salesactivities by the audit and compliancefunctions.

b. Determine the adequacy of the BHC’smanagement policies and procedures forensuring that any deficiencies noted insuch reviews are corrected, and ascertainwhether any such deficiencies are beingadequately addressed.18

10. Insurance underwriter oversight of agent/agency activities.a. Determine if the banking organization

has adequate policies and procedures toreview and resolve any issues or con-cerns raised by an insurance underwriterregarding the producers used by, or affili-ated with, the BHC.19

b. Determine whether any of the insuranceunderwriters conducted a periodic reviewof producers that they engaged to sellinsurance.

11. State supervisory insurance authorities.a. During discussions with the BHC’s man-

agement, determine whether state insur-ance regulators have raised any issues orconcerns in correspondence or reports.

b. Consult with the state insurance regula-tor (or regulators), as appropriate, todetermine any significant supervisoryissues, actions, or investigations. (Formultistate agencies, contacts with statesmay be prioritized on basis of the loca-tion of the agency’s head office or by adetermination of the significance of salesby state. Both financial examinations andmarket conduct examinations conductedby the state insurance departments aretargeted at insurance underwriters, notagencies. Therefore, information avail-able from the states pertaining to agen-cies may be very limited.)

12. Operational risk assessment. Ascertain fromBHC management whether there are—a. any significant operational problems or

concerns relating to insurance or annuitysales activities;

b. policies and procedures in place to ensureaccurateand timely reporting to theBHC’smanagement of insurance or annuity salesactivity plans, financial results, and sig-nificant consumer complaints or lawsuitsor compliance issues, such as errors andomissions claims;20

c. appropriate policies and procedures atthe BHC to ensure accurate reporting of

18. Enforcement of the privacy provisions of the GLB Actas they relate to state member banks is the responsibility ofthe Board’s Division of Consumer and Community Affairs.However, enforcement of the privacy provisions of the GLBAct with respect to the insurance activities of nondepositorysubsidiaries of a state member bank is the responsibility of thestate insurance regulators.

19. Insurance underwriters generally have procedures todetermine whether individual producers affiliated with agen-cies are selling the underwriters’ products in conformancewith applicable laws and regulations. These reviews’ findingsand conclusions should be available to the state memberbank’s management.

20. Errors and omissions insurance should be in place toprotect the state member bank against loss sustained becauseof an error or oversight, such as failure to issue an insurancepolicy. A tracking system to monitor errors and omissionclaims should be in place and monitored by the state memberbank, as appropriate. See section 4040.1, ‘‘Management ofInsurable Risks,’’ of the Commercial Bank ExaminationManual.



insurance or annuity sales activity onFederal Reserve regulatory reports (Deter-mine from applicable Board or ReserveBank contacts if there are any outstand-ing issues with respect to potentialreporting errors on submitted FederalReserve reports, BHC and bank callreports, or other applicable reports. If so,seek resolution of the issues); and

d. adequate disaster-recovery plans and pro-cedures to protect the BHC from loss ofdata related to insurance or annuity salesactivities.

3950.0.10.2 Consumer Protection in Salesof Insurance Regulation

These examination procedures apply only to theexamination of state member banks. The proce-dures are provided for the BHC examiner’sinformation only.

The following procedures should be risk-focused in accordance with the Federal Reserve’srisk-focused framework for supervising bankingorganizations. The procedures should be carriedout as necessary to adequately assess the statemember bank’s compliance with the ConsumerProtection inSalesof Insurance (CPSI) regulation.

1. Determine the role of the state memberbank’s board of directors and managementin ensuring compliance with the CPSI regu-lation and applicable state consumerregulations.

2. Evaluate the management information sys-tem (MIS) reports the state member bank’sboard or designated committee relies on tomonitor compliance with the consumer regu-lations and to track complaints and com-plaint resolution.

3. Review the state member bank’s policiesand procedures to ensure they are consistentwith the CPSI regulation, and conduct trans-action testing, as necessary, in the followingareas:21

a. disclosures, advertising, and promotionalmaterials

b. consumer acknowledgmentsc. physical separation from areas of deposit-

taking activitiesd. qualifications and licensing for insurance

personnele. compliance programs and internal auditsf. hiring, training, and supervision of insur-

ance or annuity sales personnel employeddirectly by the state member bank, or ofthird parties selling insurance or annuityproducts at a state member bank office oron behalf of the state member bank

g. compensation practices and training forpersonnel making referrals

4. If a third party sells insurance or annuitiesat the state member bank’s offices or onbehalf of the state member bank, review thestate member bank’s policies and proce-dures for ensuring that the third party com-plies with the CPSI regulation and otherrelevant policies and procedures of the bank.

5. Review the state member bank’s processfor identifying and resolving consumer com-plaints related to the sale of insurance prod-ucts and annuities.

6. Obtain and review the record of consumercomplaints related to the CPSI regulation.These records are available from the Board’sDivision of Consumer and CommunityAffairs’ database. (See CP letter 2001-11.)

7. Include examination findings, as appropri-ate, in the commercial bank examinationreport or in other communications to thebank, as appropriate, that pertain to safety-and-soundness reviews of the bank.

3950.0.11 INTERNAL CONTROLQUESTIONNAIRE

3950.0.11.1 Risk Assessment ofInsurance and Annuity Sales Activities

3950.0.11.1.1 Program Management

1. Does the BHC have a comprehensive pro-gram to ensure that its insurance and annu-ity sales activities are conducted in a safeand sound manner?

2. Does the BHC have appropriate writtenpolicies and procedures commensurate withthe volume and complexity of the insuranceor annuity sales activities?

3. Has management obtained the approval ofthe board of directors for the program scopeand the associated policies and procedures?

4. Have reasonable precautions been taken toensure that disclosures to customers for

21. If the examiner determines that transaction testing of afunctionally regulated nonbank affiliate of the state memberbank is appropriate in order to determine the state memberbank’s compliance with the CPSI regulation, the examinershould first consult with and obtain approval from appropriatestaff of the Board’s Division of Banking Supervision andRegulation.



insurance or annuity sales and solicitationsare complete and accurate and are in com-pliance with applicable laws and regulations?

5. Does the BHC’s management effectivelyoversee the insurance or annuity salesactivities, including those involving thirdparties?

6. Does the BHC have an effective indepen-dent internal audit and compliance programin place to monitor retail sales of insuranceor annuity products?

7. Does the BHC appropriately train andsupervise employees conducting insuranceor annuity sales activities?

3950.0.11.1.2 Management InformationSystems

8. Does the BHC’s insurance program man-agement plan establish the appropriate man-agement information systems (MIS) neces-sary for the banking organization’s board ofdirectors to properly oversee the insuranceor annuity sales activities?

9. Does the MIS provide sufficient informa-tion to allow for the evaluation and mea-surement of the effect of actions taken toidentify, track, and resolve any issues rela-tive to compliance with the CPSI regulation?

10. Does the MIS include sales volumes andtrends, profitability, policy exceptions andassociated controls, customer complaints,and other information providing evidenceof compliance with laws and establishedpolicies?

3950.0.11.1.3 Compliance Programs andInternal Audits

11. Are there policies and procedures in placeto ensure that insurance or annuity salesactivities are conducted in compliance withapplicable laws and regulations?

12. Do compliance procedures identify poten-tial conflicts of interest and how such con-flicts should be addressed?

13. Do the compliance procedures provide asystem to monitor customer complaints andtrack their resolution?

14. When applicable, do compliance procedurescall for verification that third-party sales arebeing conducted in a manner consistentwith the agreement governing the third par-

ty’s arrangement with the BHC?15. Is the compliance function conducted inde-

pendently of the insurance or annuity salesand management activities?

16. Docompliancepersonneldetermine thescopeand frequency of the insurance-productreview?

17. Are findings of insurance or annuity salesactivity compliance reviews periodicallyreported directly to the BHC’s board ofdirectors or a designated committee thereof?

3950.0.11.2 Consumer Protection in Salesof Insurance Regulation

This internal control questionnaire applies onlyto the examination of state member banks. It isprovided for the BHC examiner’s informationonly.

If applicable, review the state member bank’sinternal controls, policies, practices, and proce-dures for retail insurance or annuity sales activi-ties conducted by the bank on bank premises oron behalf of the bank. The bank’s programmanagement for such activities should be welldocumented and should include appropriate per-sonnel training, as well as compliance and audit-function coverage of all efforts to ensure com-pliance with the provisions of the Board’s CPSIregulation.

3950.0.11.2.1 Advertising andPromotional Materials

1. Do advertising materials associated with theinsurance or annuity sales program createan erroneous belief that—a. an insurance product or annuity sold or

offered for sale by the state memberbank, or on behalf of the bank, is backedby the federal government or the bank,or that the product is insured by theFDIC?

b. an insurance product or annuity thatinvolves investment risk does not, infact, have investment risk, including thepotential that principal may be lost andthe product may decline in value?

2. Does a review of advertising for insuranceproducts or annuities sold or offered for salecreate an erroneous impression that—a. the state member bank or an affiliate or

subsidiary may condition the grant of anextension of credit to a consumer on thepurchase of an insurance product or



annuity by the consumer from the bankor an affiliate or subsidiary of the bank?

b. the consumer is not free to purchase aninsurance product or annuity from anothersource?

3950.0.11.2.2 Disclosures

3. In connection with the initial purchase of aninsurance product or annuity by a con-sumer, does the initial disclosure to the con-sumer, except to the extent the disclosurewould not be accurate, state that—a. the insurance product or annuity is not a

deposit or other obligation of, or is notguaranteed by, the state member bank oran affiliate of the bank?

b. the insurance product or annuity is notinsured by the FDIC or any other agencyof the United States, the state memberbank, or (if applicable) an affiliate of thebank?

c. in the case of an insurance product orannuity that involves an investment risk,there is risk associated with the product,including the possible loss of value?

4. In the case of an application for credit, inconnection with which an insurance prod-uct or annuity is solicited, offered, or sold,is a disclosure made that the state memberbank may not condition an extension ofcredit on either—a. the consumer’s purchase of an insurance

product or annuity from the bank or anyof its affiliates?

b. the consumer’s agreement not to obtain,or a prohibition on the consumer’sobtaining, an insurance product or annu-ity from an unaffiliated entity?

5. Are the disclosures under question 3 aboveprovided orally and in writing before thecompletion of the initial face-to-face sale ofan insurance product or annuity to aconsumer?

6. Are the disclosures under question 4 abovemade orally and in writing at the time theconsumer applies in a face-to-face interac-tion for an extension of credit in connectionwith which insurance is solicited, offered,or sold?

7. If a sale of an insurance product or annuityis conducted by telephone, are the disclo-sures under question 3 above provided inwriting, by mail, within three business days?

8. If an application for credit is made by tele-phone, are the disclosures under question 4above provided by mail to the consumer

within three business days?9. Are the disclosures under questions 3 and 4

above provided through electronic mediainstead of on paper, only if the consumeraffirmatively consents to receiving the dis-closures electronically, and only if the dis-closures are provided in a format that theconsumer may retain or obtain later?

10. Are disclosures made through electronicmedia, for which paper or oral disclosuresare not required, presented in a meaningfulform and format?

11. Are disclosures conspicuous, simple, direct,readily understandable, and designed to callattention to the nature and significance ofthe information provided?

12. Are required disclosures presented in a mean-ingful form and format?

3950.0.11.2.3 Consumer Acknowledgment

13. At the time a consumer receives the requireddisclosures, or at the time of the consumer’sinitial purchase of an insurance product orannuity, is a written acknowledgment fromthe consumer that affirms receipt of thedisclosures obtained?

14. If the required disclosures are provided inconnection with a transaction that is con-ducted by telephone—a. has an oral acknowledgment of receipt

of the disclosures been obtained and issufficient documentation maintained toshowthat theacknowledgmentwasgiven?

b. have reasonable efforts to obtain a writ-ten acknowledgment from the consumerbeen made?

3950.0.11.2.4 Physical Separation fromDeposit Activities

15. Does the state member bank, to the extentpracticable—a. keep the area where the bank conducts

transactions involving the retail sale ofinsurance products or annuities physi-cally segregated from the areas whereretail deposits are routinely accepted fromthe general public?

b. identify the areas where insurance prod-uct or annuity sales activities occur?

c. clearly delineate and distinguish insur-ance and annuity sales areas from the



areas where the bank’s retail deposit-taking activities occur?

3950.0.11.2.5 Qualifications andLicensing

16. Does the state member bank permit anyperson to sell or offer for sale any insuranceproduct or annuity in any part of its officeor on its behalf, only if the person is at alltimes appropriately qualified and licensedunder applicable state insurance licensingstandards for the specific products beingsold or recommended?

3950.0.11.2.6 Hiring, Training, andSupervision

17. Have background investigations of prospec-tive employees that will sell insurance prod-ucts or annuities been completed?

18. When a candidate for employment has pre-vious insurance experience, has a review todetermine whether the individual has beenthe subject of any disciplinary actions bystate insurance regulators been completed?

19. Do all insurance or annuity sales personnelor third-party sales personnel conductingsales activities at or on behalf of the statemember bank receive appropriate trainingand continue to meet licensing require-ments?

20. Does training address policies and proce-dures for sales of insurance and annuityproducts, and does it cover personnel mak-ing referrals to a licensed insurance producer?

21. Does training ensure that personnel makingreferrals about insurance products or annu-ities are properly handling all inquiries soas not to be deemed to be acting as unli-censed insurance agents or registered (orequivalently trained) securities sales repre-sentatives (for insurance products that arealso securities) if they are not qualified?

22. When insurance products or annuities aresold by the bank or third parties at an officeof, or on behalf of, the organization, doesthe institution have policies and proceduresto designate, by title or name, the individu-als responsible for supervising insurancesales activities, as well as the referral activi-ties of bank employees not authorized tosell these products?

23. Does the bank designate supervisory per-

sonnel responsible for monitoring compli-ance with any third-party agreement, aswell as with the CPSI regulation?

3950.0.11.2.7 Referrals

24. Are fees paid to nonlicensed personnel whoare making referrals to qualified insuranceor annuity salespersons limited to a one-time, nominal fee of a fixed dollar amountfor each referral, and is the fee unrelated towhether the referral results in a salestransaction?

3950.0.11.2.8 Third-Party Agreements

25. Does the state member bank’s managementconduct a comprehensive review of a thirdparty before entering into any arrangementto conduct insurance or annuity sales activi-ties through the third party?

26. Does the review include an assessment ofthe third party’s financial condition, man-agement experience, reputation, and abilityto fulfill its contractual obligations to thebank, including compliance with applicableconsumer protection laws and regulations?

27. Does the board of directors or a designatedcommittee thereof approve any agreementwith the third party?

28. Does the agreement outline the duties andresponsibilities of each party; describe thethird-party activities permitted on the insti-tution’s premises; address the sharing oruse of confidential customer information;and define the terms for use of the bank’soffice space, equipment, and personnel?

29. Does the third-party agreement specify thatthe third party will comply with all applica-ble laws and regulations and will conductits activities in a manner consistent with theCPSI regulation, if applicable?

30. Does the agreement authorize the bank tomonitor a third party’s compliance with theagreement, as well as to have access tothird-party records considered necessary toevaluate compliance?

31. Does the agreement provide for indemnifi-cation of the institution by the third partyfor any losses caused by the conduct of thethird party’s employees in connection withits insurance or annuity sales activities?

32. If an arrangement includes dual employees,does the agreement provide for writtenemployment contracts that specify the dutiesof these employees and their compensationarrangements?



33. If the bank contracts with a functionallyregulated third party, does the bank obtain,asappropriate, any relevant regulatory reportsof examination of the third party?

34. How does the bank ensure that a third partyselling insurance or annuity products at oron behalf of the bank complies with allapplicable regulations, including the CPSIregulation?

35. How does the bank ensure that any thirdparty or dual employee selling insurance orannuity products at or on behalf of the bankis appropriately trained to comply with theminimum disclosures and other require-ments of the Board’s CPSI regulation andapplicable state regulations?

36. Does the bank obtain and review copies ofthird-party training and compliance materi-als to monitor the third party’s performance

regarding its disclosure and trainingobligations?

3950.0.11.2.9 Consumer Complaints

37. Does the state member bank have policiesand procedures for handling customer com-plaints related to insurance and annuitysales?

38. Does the customer complaint process pro-vide for the recording and tracking of allcomplaints?

39. Does the state member bank require peri-odic reviews of complaints by compliancepersonnel? Is a review by the state memberbank’s board and senior managementrequired for significant compliance issuesthat may pose risk to the bank?



Establishment of an Intermediate Holding Company(Financial Stability) Section 3980.0

3980.0.1 ADDITIONAL BOARDAUTHORITY FOR CERTAINNONBANK FINANCIAL COMPANIESAND BANK HOLDING COMPANIES

3980.0.1.1 Establishment of anIntermediate Holding Company

3980.0.1.1.1 Action the Board MayRequire

Pursuant to 12 U.S.C. 5667, if a nonbank finan-cial company supervised by the Board of Gover-nors of the Federal Reserve System (Board)conducts activities other than those that aredetermined to be financial in nature or inciden-tal thereto under section 4(k) of the BHC Act(12 U.S.C. 1843 (k)), the Board is authorized torequire the company to establish and conduct allor a portion of such activities that are deter-mined to be financial in nature or incidentalthereto in or through an intermediate holdingcompany. The intermediate holding companymust be established in accordance with theBoard’s regulation no later than 90 days (orother longer appropriate time), after the date onwhich the Board notifies the nonbank financialcompany of the determination.

3980.0.1.1.2 Required Board Actions

The Board must require a nonbank financialcompany to establish an intermediate holdingcompany, if it makes a determination that theestablishment of such an intermediate holdingcompany is necessary to

• appropriately supervise activities that are deter-mined to be financial in nature or incidentalthereto or

• ensure that supervision by the Board does notextend to the commercial activities of thenonbank financial company.

3980.0.2 Internal Financial Activities

Activities that are determined to be financial innature or incidental thereto under section 4(k) ofthe BHC Act do not include internal financialactivities, including internal treasury, invest-ment, and employee benefit functions. If aninternal financial activity was engaged in for thecompany or an affiliate and a non-affiliate ofsuch company during the year prior to July 21,2010, the company (or an affiliate of an interme-

diate holding company or subsidiary of an inter-mediate holding company) may continue toengage in such activity, provided that not lessthan 2/3 of the assets or 2/3 of the revenuesgenerated from the activity are from or attribut-able to the company or an affiliate. These prior-engaged activities are subject to the Board’sdetermination of whether engaging in such anactivity presents undue risk to the company orto the financial stability of the United States.

3980.0.3 Source of Strength

A company that directly or indirectly controlsan intermediate holding company shall serve asa source of strength to its subsidiary intermedi-ate holding companies.

3980.0.4 Parent Company Reports

The Board is authorized to require reports underoath from a company that controls an intermedi-ate company and from its appropriate officers ordirectors, solely for the purpose of ensuringcompliance with the provisions of section 12U.S.C. 5667, including assessing the ability ofthe company to (1) serve as a source of strengthto its subsidiary intermediate holding companyand (2) enforce compliance.

3980.0.5 Limited Parent CompanyEnforcement

The Board may enforce compliance with theprovisions of 12 U.S.C. 5667 that are applicableto any company that controls an intermediateholding company under section 8 of the FederalDeposit Insurance Act (FDI Act) (see 12 U.S.C.1818), and the company will be subject to eachsuch section in the same manner and to the sameextent as if the company were a bank holdingcompany.

3980.0.5.1 Application of Other Act

Any violation of 12 U.S.C. 5667 by any com-pany that controls and intermediate holdingcompany also may be treated as a violation ofthe FDI Act.
