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Banking Interpretations

NYBL 96(1)

March 28, 2008


In your July 27, 2006 letter ("July 2006 Letter") to then-Deputy Superintendent and Counsel Kelsey, you asked the Banking Department ("Department") to confirm that the proposed hedging transactions described in the Letter are consistent with the authority granted by the Department to The Bank of New York ("BNY" or "Bank") to conduct certain equity derivatives transactions and related hedging activities. The previous authority was granted in a letter dated April 25, 2003 from Sara A. Kelsey to Marcia Wallace (the "April 2003 Letter") and a letter dated May 1, 2003 from P. Vincent Conlon to Marcia Wallace (the "Approval Letters").1

The Bank of New York Capital Markets Limited ("Limited"), a United Kingdom broker-dealer subsidiary of the Bank, proposes to engage in certain hedging transactions with the Bank relating to (i) Limited's purchases in the secondary market, as described below, of certain equity-linked notes issued by unaffiliated third parties ("ELNs") through or from the Bank's U.S. registered broker-dealer affiliate, BNY Capital Markets, Inc. ("INC"), and (ii) Limited's purchases in the secondary market of ELNs from other market participants, including U.S. broker-dealers, which are not affiliated with Limited.

INC is a registered broker-dealer that is an indirect subsidiary of The Bank of New York Company, Inc. ("Holding Co."), the Bank's holding company. Limited is a U.K.-registered broker-dealer that is a direct subsidiary of the Bank's investment Edge Act corporation, BNY International Financing Corporation. The ELNs are notes issued by unaffiliated third-parties with certain terms that tie the obligations of the issuer to the performance of a designated equity security, one or more baskets of equity securities or one or more equity index or indices. ELNs will not be tied to the performance of any equity security issued by Holding Co. or any of its affiliates.

The Proposal

Limited wishes to enter into equity derivatives transactions with the Bank in order to hedge exposure resulting from Limited's acquisition of ELNs. Limited may acquire ELNs in either one of two situations. The first situation involves ELNs identified by INC.INC may be approached by its clients and by investors in the marketplace to purchase ELNs held by them in the secondary market or INC may otherwise become aware of the availability of ELNs in the secondary market. In such instances, INC may identify these ELNs to Limited so that Limited may consider purchasing them, if such purchases are consistent with Limited's business purpose and objectives. The second situation involves Limited seeking to acquire ELNs in the secondary market from an unaffiliated entity, in the ordinary course of Limited's business as a regulated U.K. broker-dealer.  If the unaffiliated entity is located in the United States, such purchases will be made in accordance with U.S. law.  Limited wishes to hedge its exposure relating to these purchases of ELNs by entering into equity derivatives transactions with the Bank.

In the first situation, if Limited determines that it is interested in purchasing ELNs through or from INC, then either one of the following may occur: (1) INC, acting as Limited's agent, in compliance with the requirements of rule 15a-6 under the Securities Exchange Act of 1934, will purchase such ELNs for the account of Limited; or (2) INC will purchase ELNs as riskless principal and resell them to Limited, in compliance with the requirements of rule 15a-6 of the Securities Exchange Act of 1934.2

Limited expects to market to non-U.S. investors the ELNs which it has purchased as described above.  It will not sell these ELNs back into the United States. Limited is authorized to and has the ability to deal in notes issued by third parties, such as ELNs. Limited will mark-to-market the ELNs held by it.

Limited expects to hedge its holdings of ELNs.  For several reasons, the Bank would like to serve as a counterparty to Limited with respect to such hedges through the execution of swaps and other derivative transactions between Limited and the Bank.3 These reasons include (i) the benefit to the Bank of earning fees and hedge transaction payments paid by Limited and (ii) the benefit to Limited of more timely execution of hedge transactions, because the Limited staff are well acquainted with the Bank's staff, processes and procedures.


In the April 2003 Letter, the Department concurred that the Bank had the authority, pursuant to the "incidental powers" clause in Banking Law Section 96.1 to enter into equity derivatives transactions, as long as they are (i) cash-settled; (ii) customer-driven (i.e. entered into with third-party customers for legitimate customer business purposes such as reducing the customer's exposure to various risks); (iii) conducted as a means of financial intermediation, and (iv) "matched" by offsetting transactions or hedged on a portfolio basis to minimize equity price risk. In the April 2003 Letter, the Department also recognized that the Bank has the legal authority, pursuant to the "incidental powers" clause to acquire physical equities to match or hedge equity derivative transactions, but not for speculative investment purposes.

When the April 2003 Letter was issued, the Bank stated that it did not plan to enter into equity derivatives transactions with affiliates, and it represented to the Department that, should its plans change, the Bank would consult the Department prior to engaging in such transactions. Thus, the Bank is now requesting the Department's consent to engage in equity derivatives with Limited as described above. In effect, the Bank is seeking a modification of the "customer-driven" requirement as expressed in the April 2003 Letter to the effect that the Bank's "customers" need not be independent third-party customers.

The February 2005 Letter reviews what is meant by the term "customer-driven" as used in, for example, interpretations of the Office of the Comptroller of the Currency ("OCC") permitting banks to engage in various derivatives activities. The Bank4 cites certain precedents to stand for the proposition that a transaction is customer-driven if the bank is providing a legitimate customer service to its clientele and engaging in a "modern form of financial intermediation." A bank may achieve this by acting as a conduit to pass the risk on to others who are willing to assume those financial risks. The Bank suggests, however, that the key element in determining whether a transaction is customer-driven is that the transaction is provided by the Bank to manage customer risk and is not entered into as a speculative or proprietary position at the Bank. The Bank suggests that the Department's own April 2003 Letter, where the Department determined that the Bank's equity derivatives business is a form of financial intermediation, stands for this proposition. Although the April 2003 Letter excluded engaging in equity derivatives with affiliates, you believe that this exclusion was not a necessary condition to the Department's ultimate conclusion.

The February 2005 Letter notes that, in terms of banking powers, there would seem to be no reason why the customer could not be a bank affiliate seeking to manage its risk. The banking laws have long recognized that an affiliate can be a customer for bank services such as loans. Thus Section 23A of the Federal Reserve Act is specifically addressed to providing safeguards when an affiliate borrows as a customer of the bank, and Section 23B of the Federal Reserve Act stands for the proposition that an affiliate customer cannot receive services on terms more favorable than a non­affiliate customer. The February 2005 Letter also points out that the OCC has recognized that bank holding company affiliates enter into derivative transactions to manage risk for the very reasons that the Bank wishes to do so. "Many multibank holding companies elect to manage risks by conducting derivatives transactions with their affiliates rather than external counterparties. Such strategies centralize control of price and credit exposures (e.g. credit and compliance) of dealing with external counterparties.”5 The Bank commits that the inter-affiliate derivatives will comply with the Federal Reserve Board's Regulation W.6

Finally, in the February 2005 Letter, the Bank acknowledges its understanding that the Department's condition excluding affiliate transactions was imposed to address the possibility that inter-affiliate derivatives might be abused to manufacture accounting results within a consolidated group. The Bank argues, however, that in the case of the Bank's proposal, because the risk transferred through inter-affiliate derivatives will always be transferred in the final analysis to an unaffiliated market participant, the possibility of such abuse is remote. Also, the inter­affiliate equity derivatives in connection with hedging transactions arise between the Bank's broker-dealer affiliate and unaffiliated market participants, providing additional market discipline on such transactions. The Bank also states that it will comply with all relevant and generally accepted accounting principles, including FAS 133, in recording these transactions.

In a 2005 Interpretive Letter, the OCC expressly permitted a national bank to engage in equity derivatives transactions with certain of its affiliates and subsidiaries that mirror the affiliates' and subsidiaries' transactions with their customers. (See OCC Interpretive Letter #1018, dated February 10, 2005). The national bank agreed that it would only mirror equity transactions with subsidiaries and affiliates that were customer-driven and bank-permissible. Further, due to regulatory considerations, the bank agreed not to conduct mirror transactions with affiliates or subsidiaries that are U.S.-registered broker-dealers.7  In the cited interpretive letter, the OCC also indicated that it would be permissible for the national bank to hedge the risks of the inter-affiliate equity derivatives transactions in the same manner as it hedges the risks of the bank's existing equity derivatives business.

We note that the terms of BNY's current proposal would appear to be consistent with the terms on which the OCC has found inter-affiliate derivatives activities to be permissible for national banks, as set forth in Interpretive Letter #1018. In particular, Limited is a non-U.S. broker-dealer affiliate of the Bank, the Bank has represented that the equity derivatives transactions between Limited and INC may be viewed as customer-driven in the sense that they arise in connection with transactions involving unaffiliated market participants.8  Accordingly, and based upon the reasoning set forth above, the Department would interpose no objection to the Bank engaging in inter-affiliate equity derivatives with Limited, as described in your July 27, 2006 Letter, and subject otherwise to the remaining conditions imposed by the Approval Letters on the conduct of the equity derivatives activities.

With respect to the Bank's hedging of the proposed inter-affiliate derivatives transactions with Limited, we note that the Bank requested permission to hedge the equity derivatives transactions in the same manner as permitted in the April 2003 Letter, including by acquiring equities under the same conditions as permitted for national banks, and in accordance with the Federal Reserve Board's ("FRB's") February 21, 2002 Statement Concerning the Acquisition of Stock by State Member Banks to Hedge Equity Derivative Transactions (the "FRB Statement"). In our opinion, consistent with Sections 96.1 and 97 of the New York Banking Law, the Bank may hedge permitted equity derivatives transactions (i.e. those with a subsidiary or affiliate) either by entering into other cash-settled derivatives or by acquiring up to five percent of a class of voting stock of any issuer, provided that the Bank complies with the conditions set forth in the April 2003 letter.  That is, (1) the hedging transaction may not be with the Bank's special purpose vehicle or entity or with a subsidiary of the Bank that is consolidated (under GAAP) on the Bank's balance sheet, unless that subsidiary, in turn, simultaneously or contemporaneously hedges the transaction with an entity not consolidated on the Bank's balance sheet, (2) they must be on the same terms and conditions as permitted for national banks by the OCC and for state member banks by the FRB, including that (a) the equity securities are not held for speculative purposes, (b) holding the securities is a cost­effective means of hedging, (c) the bank will not take anticipatory hedging positions or maintain residual positions in cash equities, except as necessary for the orderly establishment or unwinding of a hedging position, (d) the bank will not acquire equity securities for hedging purposes that constitute more than 5% of a class of voting securities of any issuer. We note that the FRB Statement generally interposes no objection to a state member bank acquiring equities, subject to the same terms and conditions imposed on national banks, to hedge risks arising from permissible equity derivatives transactions entered into by the bank with an unaffiliated third party.

I trust that this is helpful. If you have any questions about this letter, please feel free to contact me or Rosanne Notaro at 212.709.1663.


Marjorie E. Gross
Deputy Superintendent and General Counsel

CC:     Deputy Fredsall -NYSBD
            Lamont Wade -NYSBD
            David Logan --NYSBD
            Director Marfia -NYSBD
            Mark VanderWeide, Esq. - Federal Reserve Board
            Haeran Kim, Esq. - Federal Reserve Bank of New York

  1. The request by the Bank to engage in inter-affiliate equity derivatives transactions was initially raised in a letter dated February 11, 2005 from Michael Wiseman, Esq. of Sullivan & Cromwell ("S&C") to Sara Kelsey (the "February 2005 Letter"). In an October 5, 2005 letter to Mr. Wiseman, the Department indicated it would require more time to consider the question of inter-affiliate equity derivatives.
  2. With respect to approaches (1) and (2) above, Limited commits that it will ensure that the sale and fee or commission terms satisfy the requirements of the Federal Reserve's Regulation W.
  3. In addition to swaps, Limited's derivatives transactions with the Bank may include equity options and futures.
  4. For ease of reference, references to the Bank's analysis include the analysis made by Sullivan and Cromwell in the February 2005 Letter.
  5. February 2005 Letter, at p.9, citing and attaching as Exhibit 0 “Comptroller's Handbook, Risk Management of Financial Derivatives,” Introduction, Board Oversight (October 2001).
  6. Regulation W implements Sections 23A and 23B of the Federal Reserve Act. The Bank has adopted "23B Compliance Procedures" which would be applicable to the inter­affiliate derivatives, a copy of which was attached to the February 2005 Letter as Confidential Exhibit P. Section 23A prohibits the Bank and its subsidiaries from engaging in covered transactions with an affiliate except as authorized in that Section. Moreover, there are certain circumstances where a transaction by a bank or its subsidiary with a third person can be "attributed" to an affiliate. Section 23B contains requirements with respect to certain covered transactions, including transactions in which an affiliate acts as an agent or broker, transactions with a third party in which an affiliate is a participant and transactions that benefit an affiliate. Because the transactions you describe could be covered by Sections 23A or 23B, we believe that the bank should develop specific policies, procedures and training materials that address in a more concrete manner the compliance issues that may arise in connection with the contemplated transactions. Without trying to be exhaustive, we note that your July 2006 letter states that in order to comply with SEC Rule 15a-6, when Limited would be purchasing ELN's from a U.S. person, INC would intermediate the transaction either as agent or riskless principal (i.e. it would be a participant in the transaction within the meaning of Section 23B). In addition, it is not clear whether INC will have underwritten any of the ELN's. Either of these situations implicate a number of issues under Reg W.

    For example, if INC underwrote the ELNs and is still underwriting the securities (either because the underwriting period has not terminated or because there is a continuous offering), then the purchase by Limited would be taking place during the existence of the underwriting syndicate within the meaning of Section 23B. (Under Section 23B, the bank and its subsidiaries cannot buy a security underwritten by an affiliate during the existence of the underwriting syndicate, except with Board approval, either on a one-off basis or under a Section 23B Policy).

    If INC were acting as riskless principal for Limited or its customers in purchasing securities, it would be deemed to be selling an asset to Limited for purposes of Section 23B. The exemption contained in Section 223.42(m) of Reg W from the quantitative limits, collateral requirement and low-quality assets requirement would apply only if the ELNs were not underwritten by INC. In any event, under Section 23B, the price to Limited must be the fair market value of the security.
  7. We understand that the reason for the OCC's requirement that the bank not conduct equity derivatives transactions with a US broker-dealer affiliate is to remind banks that, as a result of the Gramm-Leach-Bliley Act, a bank is no longer exempt from registration as a broker or dealer of securities unless it meets the requirements of Section 3(a)(4) of the Securities Exchange Act and the SEC's rules thereunder.  Exchange Act Section 3(a)(4)(B)(vi) provides an exception where the bank effects transactions for the account of any affiliate of the bank other than a registered broker or dealer.
  8. Although as noted above, Limited may purchase ELNs directly from INC, in such situations INC will be acting in an intermediary capacity, either as agent or riskless principal, in transactions in which it purchases ELNs from unaffiliated market participants.