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Futures Brokerage Activities and Futures Commission Merchants Section 3030.1 Bank holding company subsidiaries, banks (gen- erally through operating subsidiaries), Edge Act corporations, and foreign banking organizations (FBOs) operating in the United States may operate futures brokerage and clearing services involving a myriad of financial and nonfinancial futures contracts and options on futures. These activities can involve futures exchanges and clearinghouses throughout the world. In general, most institutions conduct these activities as futures commission merchants (FCMs). FCM is the term used in the Commodity Exchange Act to refer to registered firms that are in the business of soliciting or accepting orders, as broker, for the purchase or sale of any exchange- traded futures contract and options on futures contracts. In connection with these activities, institutions may hold customer funds, assets, or property and may be members of futures exchanges and their associated clearinghouses. They may also offer related advisory services as registered commodity trading advisors (CTAs). The Federal Reserve has a supervisory inter- est in ensuring that the banking organizations subject to its oversight conduct their futures brokerage activities safely and soundly consis- tent with Regulations Y and K (including any terms and conditions contained in Board orders for a particular organization). Accordingly, a review of futures brokerage activities is an important element for inspections of bank hold- ing companies (BHCs), examinations of state member banks, and reviews of FBO operations. The following guidance on evaluating the futures brokerage activities of bank holding company subsidiaries, branches and agencies of foreign banks operating in the United States, or any operating subsidiaries of state member banks provides a list of procedures that may be used to tailor the scope of an examination or inspection of these activities at individual institutions. For the purposes of this discussion, the term FCM activities is used in a broad context and refers to all of an institution’s futures brokerage activities and operations. SCOPE OF GUIDANCE Examiners are instructed to take a risk-based examination approach to evaluating FCM activities—including brokerage, clearing, funds management, and advisory activities. Significant emphasis should be placed on evaluating the adequacy of management and the management processes used to control the credit, market, liquidity, legal, reputational, and operations risks entailed in these operations. Both the adequacy of risk management and the quantitative level of risk exposures should be assessed as appropriate to the scope of the FCM’s activities. The objec- tives of a particular inspection or examination should dictate the FCM activities to be reviewed and set the scope of the inspection. Examiners are also instructed to take a functional-regulatory approach to minimize duplicative inspection and supervisory burdens. Reviews and reports of functional regulators should be used to their fullest extent. However, absent recent oversight inspection, or if an examiner believes particular facts and circum- stances at the banking organization or in the marketplace deem it necessary, a review of operations that would normally be assessed by the appropriate commodities regulator may be appropriate (such as review of front- or back- office operations). When futures brokerage occurs in more than one domestic or foreign affiliate, examiners should assess the adequacy of the management of the futures brokerage activities of the consoli- dated financial organization to ensure that the parent organization recognizes and effectively manages the risks posed by its various futures subsidiaries. Accordingly, in reviewing futures brokerage operations, examiners should identify all bank holding company, bank operating, or FBO subsidiaries that engage in FCM activities and the scope of those activities. Not all subsid- iaries may need to be reviewed to assess the risk management of the consolidated organization. Selection of the particular FCM subsidiaries to be reviewed should be based on an assessment of the risks posed by their activities to the consolidated organization. This guidance primarily addresses the assess- ment of activities associated with futures bro- kerage operations. Any proprietary trading that occurs at an FCM should be assessed in connec- tion with the review of proprietary trading activities of the consolidated financial organiza- tion, using the appropriate guidance from other sections of this manual. Similarly, when a review of futures advisory activities is planned, exam- Trading and Capital-Markets Activities Manual February 1998 Page 1

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Futures Brokerage Activities and Futures CommissionMerchants Section 3030.1

Bank holding company subsidiaries, banks (gen-erally through operating subsidiaries), Edge Actcorporations, and foreign banking organizations(FBOs) operating in the United States mayoperate futures brokerage and clearing servicesinvolving a myriad of financial and nonfinancialfutures contracts and options on futures. Theseactivities can involve futures exchanges andclearinghouses throughout the world. In general,most institutions conduct these activities asfutures commission merchants (FCMs). FCM isthe term used in the Commodity Exchange Actto refer to registered firms that are in thebusiness of soliciting or accepting orders,asbroker,for the purchase or sale of any exchange-traded futures contract and options on futurescontracts. In connection with these activities,institutions may hold customer funds, assets, orproperty and may be members of futuresexchanges and their associated clearinghouses.They may also offer related advisory services asregistered commodity trading advisors (CTAs).

The Federal Reserve has a supervisory inter-est in ensuring that the banking organizationssubject to its oversight conduct their futuresbrokerage activities safely and soundly consis-tent with Regulations Y and K (including anyterms and conditions contained in Board ordersfor a particular organization). Accordingly, areview of futures brokerage activities is animportant element for inspections of bank hold-ing companies (BHCs), examinations of statemember banks, and reviews of FBO operations.The following guidance on evaluating the futuresbrokerage activities of bank holding companysubsidiaries, branches and agencies of foreignbanks operating in the United States, or anyoperating subsidiaries of state member banksprovides a list of procedures that may be used totailor the scope of an examination or inspectionof these activities at individual institutions. Forthe purposes of this discussion, the termFCMactivitiesis used in a broad context and refers toall of an institution’s futures brokerage activitiesand operations.

SCOPE OF GUIDANCE

Examiners are instructed to take a risk-basedexamination approach to evaluating FCMactivities—including brokerage, clearing, funds

management, and advisory activities. Significantemphasis should be placed on evaluating theadequacy of management and the managementprocesses used to control the credit, market,liquidity, legal, reputational, and operations risksentailed in these operations. Both the adequacyof risk management and the quantitative level ofrisk exposures should be assessed as appropriateto the scope of the FCM’s activities. The objec-tives of a particular inspection or examinationshould dictate the FCM activities to be reviewedand set the scope of the inspection.

Examiners are also instructed to take afunctional-regulatory approach to minimizeduplicative inspection and supervisory burdens.Reviews and reports of functional regulatorsshould be used to their fullest extent. However,absent recent oversight inspection, or if anexaminer believes particular facts and circum-stances at the banking organization or in themarketplace deem it necessary, a review ofoperations that would normally be assessed bythe appropriate commodities regulator may beappropriate (such as review of front- or back-office operations).

When futures brokerage occurs in more thanone domestic or foreign affiliate, examinersshould assess the adequacy of the managementof the futures brokerage activities of the consoli-dated financial organization to ensure that theparent organization recognizes and effectivelymanages the risks posed by its various futuressubsidiaries. Accordingly, in reviewing futuresbrokerage operations, examiners should identifyall bank holding company, bank operating, orFBO subsidiaries that engage in FCM activitiesand the scope of those activities. Not all subsid-iaries may need to be reviewed to assess the riskmanagement of the consolidated organization.Selection of the particular FCM subsidiaries tobe reviewed should be based on an assessmentof the risks posed by their activities to theconsolidated organization.

This guidance primarily addresses the assess-ment of activities associated with futures bro-kerage operations. Any proprietary trading thatoccurs at an FCM should be assessed in connec-tion with the review of proprietary tradingactivities of the consolidated financial organiza-tion, using the appropriate guidance from othersections of this manual. Similarly, when a reviewof futures advisory activities is planned, exam-

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iners should refer to investment advisory inspec-tion guidance in theBank Holding CompanySupervision Manualand theTrust ExaminationManual as appropriate.

EVALUATION OF FCM RISKMANAGEMENT

Consistent with existing Federal Reserve poli-cies, examiners should evaluate the risk-management practices of FCM operations andensure that this evaluation is incorporatedappropriately in the rating of risk managementunder the bank (CAMELS), BHC (BOPEC),and FBO (ROCA) rating systems. Accordingly,examiners should place primary considerationon findings related to the adequacy of (1) boardand senior management oversight; (2) policies,procedures, and limits used to control risks;(3) risk measurement, monitoring, and reportingsystems; and (4) internal controls and auditprograms. General considerations in each ofthese areas are discussed below.

Board and Senior ManagementOversight

The board of directors has the ultimate respon-sibility for the level of risks taken by theinstitution. Accordingly, the board, a designatedsubcommittee of the board, or a high level ofsenior management should approve overallbusiness strategies and significant policies thatgovern risk-taking in the institution’s FCMactivities. In particular, the board or a committeethereof should approve policies that identifyauthorized activities and managerial oversight,and articulate risk tolerances and exposure lim-its of FCM activities. The board should alsoactively monitor the performance and risk pro-file of its FCM activities. Directors and seniormanagement should periodically review infor-mation that is sufficiently detailed and timely toallow them to understand and assess the variousrisks involved in these activities. In addition, theboard or a delegated committee should periodi-cally reevaluate the institution’s business strat-egies and major risk-management policies andprocedures, emphasizing the institution’s finan-cial objectives and risk tolerances.

For their part, senior management is respon-sible for ensuring that policies and proceduresfor conducting FCM activities on both a long-range and day-to-day basis are adequate. Thesepolicies should be approved and reviewed annu-ally by senior management or a designatedsubcommittee of the board; the consistency ofthese policies with parent-company limits orother directions pertaining to the FCM’s activi-ties should be confirmed. Management mustalso maintain (1) clear lines of authority andresponsibility for managing operations and therisks involved, (2) appropriate limits on risk-taking, (3) adequate systems and standardsfor measuring and tracking risk exposures andmeasuring finanical performance, (4) effectiveinternal controls, and (5) a comprehensive risk-reporting and risk-management review process.To provide adequate oversight, managementshould fully understand the risk profile of theirFCM activities. Examiners should review reportsto senior management and evaluate whether thereports provide both good summary informationand sufficient detail to enable management toassess and manage the FCM’s risk. As part oftheir oversight responsibilities, senior manage-ment should periodically review the organiza-tion’s risk-management procedures to ensurethat they remain appropriate and sound.

Management should also ensure that activitiesare conducted by competent staff whose tech-nical knowledge and experience are consistentwith the nature and scope of the institution’sactivities. There should be sufficient depth instaff resources to manage these activities if keypersonnel are not available. Management shouldalso ensure that back-office and financial-controlresources are sufficient to effectively manageand control risks. Risk-measurement, monitor-ing, and control functions should have clearlydefined duties. Separation of duties in key ele-ments of the risk-management process should beadequate to avoid potential conflicts of interest.The nature and scope of these safeguards shouldbe in accordance with the scope of the FCM’sactivities.

Policies, Procedures, and Limits

FCMs should maintain written policies andprocedures that clearly outline their approachfor managing futures brokerage and relatedactivities. Such policies should be consistent

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with the organization’s broader business strate-gies, capital adequacy, technical expertise, andgeneral willingness to take risk. Policies, proce-dures, and limits should address the relevantcredit, market, liquidity, reputation, and opera-tions risks in light of the scope and complexityof the FCM’s activities. Policies and proceduresshould establish a logical framework for limit-ing the various risks involved in an FCM’sactivities and clearly delineate lines of respon-sibility and authority over these activities. Theyshould also address the approval of new productlines, strategies, and other activities; conflicts ofinterest including transactions by employees;and compliance with all applicable legal require-ments. Procedures should incorporate and imple-ment the parent company’s relevant policies,and should be consistent with Federal ReserveBoard regulations and any applicable Boardorders.

A sound system of integrated limits andrisk-taking guidelines is an essential componentof the risk-management process. This systemshould set boundaries for organizational risk-taking and ensure that positions that exceedcertain predetermined levels receive promptmanagement attention, so they can be eitherreduced or prudently addressed.

Risk Measurement, Monitoring, andReporting

An FCM’s system for measuring the credit,market, liquidity, and other risks involved in itsactivities should be as comprehensive and accu-rate as practicable and should be commensuratewith the nature of its activities. Risk exposuresshould be aggregated across customers, prod-ucts, and activities to the fullest extent possible.Examiners should evaluate whether the riskmeasures and the risk-measurement process aresufficiently robust to reflect accurately the dif-ferent types of risks facing the institution. Insti-tutions should establish clear standards for mea-suring risk exposures and financial performance.Standards should provide a common frameworkfor limiting and monitoring risks and should beunderstood by all relevant personnel.

An accurate, informative, and timely manage-ment information system is essential to theprudent operation of an FCM. Accordingly, theexaminer’s assessment of the quality of themanagement information system is an important

factor in the overall evaluation of the risk-management process. Appropriate mechanismsshould exist for reporting risk exposures and thefinancial performance of the FCM to its boardand parent company, as well as for internalmanagement purposes. FCMs must establishmanagement reporting policies to apprise theirboards of directors and senior management ofmaterial developments, the adequacy of riskmanagement, operating and financial perfor-mance, and material deficiencies identified dur-ing reviews by regulators and by internal orexternal audits. The FCM should also providereports to the parent company (or in the case offoreign-owned FCMs, to its U.S. parent organi-zation, if any) of financial performance; adher-ence to risk parameters and other limits andcontrols established by the parent for the FCM;and any material developments, including find-ings of material deficiencies by regulators.Examiners should determine the adequacy of anFCM’s monitoring and reporting of its riskexposure and financial performance to appropri-ate levels of senior management and to theboard of directors.

Internal Controls

An FCM’s internal-control structure is critical toits safe and sound functioning in general and toits risk-management system, in particular. Estab-lishing and maintaining an effective system ofcontrols, including the enforcement of officiallines of authority and appropriate separation ofduties—such as trading, custodial, and back-office—is one of management’s more importantresponsibilities. Appropriately segregating dutiesis a fundamental and essential element of asound risk-management and internal-control sys-tem. Failure to implement and maintain anadequate separation of duties can constitute anunsafe and unsound practice, possibly leading toserious losses or otherwise compromising thefinancial integrity of the FCM.

When properly structured, a system of inter-nal controls promotes effective operations andreliable financial and regulatory reporting, safe-guards assets, and helps to ensure compliancewith relevant laws, regulations, and institutionalpolicies. Ideally, internal controls are tested byan independent internal auditor who reportsdirectly to either the institution’s board of direc-tors or its designated committee. Personnel who

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perform these reviews should generally be inde-pendent of the function they are assigned toreview. Given the importance of appropriateinternal controls to banking organizations of allsizes and risk profiles, the results of audits orreviews, whether conducted by an internalauditor or by other personnel, should be ade-quately documented, as should management’sresponses to them. In addition, communicationchannels should allow negative or sensitivefindings to be reported directly to the board ofdirectors or the relevant board committee.

FUTURES EXCHANGES,CLEARINGHOUSES, AND FCMs

Futures exchanges provide auction markets forstandardized futures and options on futurescontracts. In the United States and most othercountries, futures exchanges and FCMs areregulated by a governmental agency. Futuresexchanges are membership organizations andimpose financial and other regulatory require-ments on members, particularly those that dobusiness for customers as brokers. In the UnitedStates and most other countries, futures exchangesalso have quasi-governmental (self-regulatory)responsibilities to monitor trading and preventfraud, with the authority to discipline or sanc-tion members that violate exchange rules. FCMsmay be members of the exchange on which theyeffect customers’ trades. When they are notmembers, FCMs must use other firms who areexchange members to execute customer trades.1

Each futures exchange has an affiliated clear-inghouse responsible for clearing and settlingtrades on the exchange and managing associatedrisks. When a clearinghouse accepts transactioninformation from its clearing members, itgenerally guarantees the performance of thetransaction to each member and becomes thecounterparty to the trade (that is, the buyer toevery seller and the seller to every buyer). Dailycash settlements are paid or collected by clear-ing members through the clearinghouse. Thecash transfers represent the difference betweenthe original trade price and the daily officialclosing settlement price for each commodityfutures contract. The two members settle their

sides of the transaction with the clearinghouse,usually by closing out the position before deliv-ery of the futures contract or the expiration ofthe option on the futures contract.

An exchange member that wishes to clear orsettle transactions for itself, customers, otherFCMs, or commodity professionals (locals ormarket makers) may become a member of theaffiliated clearinghouse (clearing member) if itis able to meet the clearinghouse’s financial-eligibility requirements. In general, these require-ments are more stringent than those required forexchange membership. For example, a clearingmember usually is required to maintain a speci-fied amount of net capital in excess of theregulatory required minimum and to make aguaranty deposit as part of the financial safe-guards of the clearinghouse. The size of thedeposit is related to the scale of the clearingmember’s activity. If it is not a member of theclearinghouse for the exchange on which acontract is executed, an FCM must arrange foranother FCM that is a clearing member to clearand settle its transactions.2

Margin requirements are an important risk-management tool for maintaining the financialintegrity of clearinghouses and their affiliatedexchanges. Clearinghouses require that theirmembers post initial margin (performance bond)on a new position to cover potential creditexposures borne by the clearinghouse. The clear-ing firm, in turn, requires its customers to postmargin. At the end of each day, and on someexchanges on an intraday basis, all positions aremarked to the market. Clearing members withpositions that have declined in value pay thatamount in cash to the clearinghouse, which thenpays the clearing members holding positionsthat have increased in value on that day. Thisprocess of transferring gains and losses amongclearing-member firms, known ascollectingvariation margin, is intended to periodically

1. A firm or trading company that maintains only aproprietary business may become a member of an exchangewithout registering as an FCM.

2. The nonmember FCM opens an account, usually on anomnibus basis, with the clearing-member FCM. Separateomnibus accounts have to be maintained for customer andnoncustomer or proprietary trading activity. If the FCM doesnot carry customer accounts by holding customer funds andmaintaining account records, the clearing member will carrythe customer’s account on afully disclosedbasis and issueconfirmations, account statements, and margin calls directly tothe customer on behalf of the introducing FCM. In such cases,the introducing FCM operates as an introducing broker (IB)and could have registered with Commodity Futures TradingCommission as such.

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eliminate credit-risk exposure from the clearing-house.3 In volatile markets, a clearinghousemay call for additional variation margin duringthe trading day, sometimes with only one hour’snotice, and failure to meet a variation (or initial)margin call is treated as a default to theclearinghouse.

Some clearinghouses also require that theirmembers be prepared to pay loss-sharing assess-ments to cover losses sustained by the clearing-house in meeting the settlement obligations of aclearing member that has defaulted on its (or itscustomers’) obligations. Such assessments arisewhen losses exceed the resources of defaultingmembers, the guaranty fund, and other surplusfunds of the clearinghouse. Each clearinghousehas its own unique loss-sharing rules.4 At leastone U.S. and one foreign exchange have unlim-ited loss-sharing requirements. Most U.S. clear-inghouses relate loss-sharing requirements tothe size of a member’s business at the clearing-house. Given the potential drain on an institu-tion’s financial resources, the exposure to loss-sharing agreements should be a significantconsideration in an institution’s decision tobecome a clearing member.

COMMODITY EXCHANGE ACT,COMMODITY FUTURESTRADING COMMISSION, ANDSELF-REGULATORYORGANIZATIONS

In the United States, the primary regulator ofexchange-traded futures activities is the Com-modity Futures Trading Commission (CFTC),which was created by and derives its authorityfrom the Commodity Exchange Act (CEA). TheCFTC has adopted registration,5 financial respon-sibility, antifraud, disclosure, and other rules forFCMs and CTAs, and has general enforcementauthority over commodities firms and profes-

sionals that buy or sell exchange-traded futurescontracts.

The futures exchanges, in addition to provid-ing a marketplace for futures contracts, aredeemed to be self-regulatory organizations(SROs) under the CEA. For example, a numberof SROs have adopted detailed uniform practicerules for FCMs, including ‘‘know your cus-tomer’’ recordkeeping rules and other formalcustomer-disclosure requirements. The NationalFutures Association (NFA) also is an SRO,although it does not sponsor a futures exchangeor other marketplace. The NFA has adoptedsales-practice rules applicable to members whodo business with customers. All FCMs that wishto accept orders and hold customer funds andassets must be members of the NFA.

The CEA and rules of the CFTC require theSROs to establish and maintain enforcement andsurveillance programs for their markets and tooversee the financial responsibility of their mem-bers.6 The CFTC has approved an arrangementunder which a designated SRO (DSRO) isresponsible for performing on-site audits andreviewing periodic reports of a member FCMthat is a member of more than one futuresexchange. The NFA is the DSRO for FCMs thatare not members of any futures exchange.

Oversight of FCMs is accomplished throughannual audits by the DSRO and the filing ofperiodic financial statements and early warningreports by FCMs, in compliance with CFTC andSRO rules. In summary, this oversight encom-passes the following three elements.

1. Full-scope audits at least once every otheryear of each FCM that carries customeraccounts.Audit procedures conform to aUniform Audit Guide developed jointly bythe SROs. The full-scope audit focuses onthe firm’s net capital computations, segrega-tion of customer funds and property, financialreporting, recordkeeping, and operations.7

3. Some foreign exchanges do not allow the withdrawal ofunrealized profits as mark-to-market variation.

4. Clearinghouses usually retain the right to use assetsowned by clearing members, but under the control of theclearinghouse (for example, proprietary margin); require addi-tional contributions of funds or assets or require the memberto purchase additional shares of the clearinghouse; or perfecta claim against the member for its share of the loss.

5. Many FCMs also are SEC-registered as broker-dealersand are subject to SEC and CFTC financial responsibilityrules.

6. CFTC Rule 1.51, contract market program for enforce-ment, requires that SROs monitor market activity and tradingpractices in their respective markets, perform on-site exami-nations (audits) of members’ books and records, reviewperiodic financial reports filed by members, and bring disci-plinary and corrective actions against members for violationsof the CEA, and of CFTC and SRO rules.

7. If an FCM is also a broker-dealer, the DSRO is notrequired to examine the FCM for compliance with net capitalrequirements if the DSRO confers with the broker-dealer’sexamining authority at least annually to determine that theFCM is in compliance with the broker-dealer’s net capitalrequirements and receives the DSRO copies of all examinations.

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The audit also reviews sales practices (includ-ing customer records, disclosures, advertise-ments, and customer complaints) and theadequacy of employee supervision. Theaudit’s scope should reflect the FCM’s priorcompliance history as well as the examiner’son-site evaluation of the firm’s internal con-trols. During the off-year, the DSROs per-form limited scope audits of member FCMs.This audit is limited to financial matters suchas a review of the FCM’s net capital compu-tations, segregation of customer funds, andits books and records.

2. FCM quarterly financial reporting require-ments.FCMs are required to file quarterlyfinancial statements (form 1-FR-FCM) withtheir DSROs. The fourth-quarter statementmust be filed as of the close of the FCM’sfiscal year and must be certified by an inde-pendent public accountant. The filings gen-erally include statements regarding changesin ownership equity, current financial condi-tion, changes in liabilities subordinated toclaims of general creditors, computation ofminimum net capital, segregation require-ments and funds segregated for customers,secured amounts and funds held in separateaccounts, and any other material informationrelevant to the firm’s financial condition. Thecertified year-end financial report also mustcontain statements of income and cash flows.

3. Early warning reports.FCMs are required tonotify the CFTC and the SROs when certainfinancial weaknesses are experienced.8 Forexample, if an FCM’s net capital falls to aspecified warning level, it must file a writtennotice within five business days and filemonthly financial reports (form 1-FR-FCM)until its net capital meets or exceeds thewarning level for a full three months. If anFCM’s net capital falls below the minimumrequired, it must cease doing business andgive telegraphic notice to the CFTC and anycommodities or securities SRO of which it isa member. Similar notices must be given bya clearing organization or carrying FCMwhen it determines that a position of an FCMmust be liquidated for failure to meet amargin call or other required deposit.

FEDERAL RESERVEREGULATION OF FCMs ANDCTAs

Bank holding companies are permitted, underRegulation Y, to engage in FCM and CTAactivities on both domestic and foreign futuresexchanges through separately incorporatednonbank subsidiaries. As a general matter, thenonbank subsidiaries of bank holding compa-nies (and some foreign banks) provide servicesto unaffiliated customers in the United Statesunder section 4(c)(8) of the Bank Holding Com-pany Act (BHC Act) and to unaffiliated custom-ers outside the United States under RegulationK.9 Banks and the operating subsidiaries ofbanks usually provide futures-related services tounaffiliated parties in the United States under thegeneral powers of the bank and to unaffiliatedparties outside the United States under Regula-tion K. These various subsidiaries may provideservices to affiliates under section 4(c)(1)(C) ofthe BHC Act.

Regulation Y permits a bank holding com-pany subsidiary that acts as an FCM to engagein other activities in the subsidiary, includingfutures advisory services and trading, as well asother permissible securities and derivativeactivities as defined in sections 225.28(b)(6)(financial and investment advisory activities)and 225.28(b)(7) (agency transactional servicesfor customer investments). Section 225.28(b)(7)specifically authorizes FCMs to provide agencyservices for unaffiliated persons in execution,clearance, or execution and clearance ofanyfutures contract and option on a futures contracttraded on an exchange in the United States andabroad. It also includes the authority to engagein other agency-type transactions, (for example,riskless principal), involving a forward contract,option, future, option on a future, and similarinstruments. Furthermore, this section codifiesthe longstanding prohibition against a parentbank holding company’s issuing any guaranteesor otherwise becoming liable to an exchange orclearinghouse for transactions effected through

8. CFTC Rule 1.12 requires the maintenance of minimumfinancial requirements by FCMs and introducing brokers.These requirements are similar to those applicable to broker-dealers under SEC rules.

9. Those nonbank subsidiaries that operate in the UnitedStates may open offices outside the United States if (1) thebank holding company’s authority under Regulation Y is notlimited geographically, (2) the foreign office is not a sepa-rately incorporated entity, and (3) the activities conducted bythe foreign office are within the scope of the bank holdingcompany’s authority under Regulation Y. In addition, a bankholding company may operate a limited foreign-based busi-ness in the United States under Regulation K.

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an FCM, except for the proprietary trades of theFCM and those of affiliates.

A well-capitalized and well-managedbankholding company, as defined in sections 225.2(r)and (s) of Regulation Y, respectively, may com-mence activities as an FCM or a CTA by filinga notice prescribed under section 225.23(a) ofRegulation Y. Bank holding companies that arenot eligible to file notices or wish to act in acapacity other than as an FCM or CTA, such asa commodities pool operator, must follow thespecific application process for these activities.Examiners should ensure that all of these activi-ties are conducted in accordance with the Board’sapproval order.

A bank holding company, bank, or FBOparent company of an FCM is expected toestablish specific risk parameters and other lim-its and controls on the brokerage operation.These limits and controls should be designed tomanage financial risk to the consolidated orga-nization and should be consistent with its busi-ness objectives and overall willingness to assumerisk.

PARTICIPATION IN FOREIGNMARKETS

Institutions frequently transact business on for-eign exchanges as either exchange or clearing-house members or through third-party brokersthat are members of the foreign exchange. Therisks of doing business in foreign markets gen-erally parallel those in U.S. markets; however,some unique issues of doing business on foreignfutures exchanges must be addressed by theFCM and its parent company to ensure that theactivity does not pose undue risks to the con-solidated financial organization.

Before doing business on a foreign exchange,an FCM should understand the legal and opera-tional differences between the foreign exchangeand U.S. exchanges. For example, the FCMshould know about local business practices andlegal precedents that pertain to business in theforeign market. In addition, the FCM shouldknow how the foreign exchange is regulated andhow it manages risk, and should develop poli-cies and the appropriate operational infrastruc-ture of controls, procedures, and personnel tomanage these risks. Accordingly, examinersshould confirm that, in considering whether andhow to participate in a foreign market, an FCM

performs due diligence on relevant legal andregulatory issues, as well as on local businesspractices. Foreign-exchange risks should beunderstood and authorized by the FCM’s parentcompany, and any limits set by the parentcompany or FCM management should be care-fully monitored. The FCM and its parent com-pany also should assess the regulatory andfinancial risks associated with exchange andclearinghouse membership in a foreign market,including an understanding of the extent towhich the foreign clearinghouse monitors andcontrols day-to-day credit risk and its loss-sharing requirements.

SPECIFIC RISKS AND THEIRRISK-MANAGEMENTCONSIDERATIONS

In general, FCMs face five basic categories ofrisk—credit risk, market risk, liquidity risk,reputation risk, and operations risk. The follow-ing discussions highlight specific considerationsin evaluating the key elements of sound riskmanagement as they relate to these risks. Thecompliance and internal-controls functions pro-vide the foundation for managing the risks of anFCM.

Credit Risk

FCMs encounter a number of different types ofcredit risks. The following discussions identifysome of these risks and discuss sound risk-management practices applicable to each.

Customer-Credit Risk

Customer-credit risk is the potential that a cus-tomer will fail to meet its variation margin callsor its payment or delivery obligations. An FCMshould establish a credit-review process for newcustomers that is independent of the marketingand sales function. It is not unusual for theFCM’s parent company (or banking affiliate) toperform the credit evaluation and provide thenecessary internal approvals for the FCM toexecute and clear futures contracts for particularcustomers. In some situations, however, theFCM may have the authority to perform thecredit review internally. Examiners should

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determine how customers are approved andconfirm that documentation in the customer’scredit files is adequate even when the approvalis performed by the parent. Customer-credit filesshould indicate the scope of the credit reviewand contain approval of the customer’s accountand credit limits. For example, customer-creditfiles may contain recent financial statements,sources of liquidity, trading objectives, and anyother pertinent information used to support thecredit limits established for the customer. Inaddition, customer-credit files should be updatedperiodically.

FCM procedures should describe howcustomer-credit exposures will be identified andcontrolled. For example, an FCM could monitora customer’s transactions, margin settlements,or open positions as a means of managing thecustomer’s credit risk. Moreover, proceduresshould be in place to handle situations in whichthe customer has exceeded credit limits. Theseprocedures should give senior managers who areindependent of the sales and marketing functionthe authority to approve limit exceptions andrequire that such exceptions be documented.

Customer-Financing Risk

Several exchanges, particularly in New Yorkand overseas, allow FCMs to finance customerpositions. These exchanges allow an FCM tolend initial and variation margin to customerssubject to taking the capital charges under theCFTC’s (or SEC’s) capital rules if the chargesare not repaid within three business days. Inaddition, some exchanges allow FCMs to financecustomer deliveries, again subject to a capitalcharge.

An FCM providing customer-financing ser-vices should adopt financing policies and proce-dures that identify customer-credit standards.The financing policies should be approved bythe parent company and should be consistentwith the FCM’s risk tolerance. In addition, anFCM should establish overall lending limits foreach customer based on a credit review that isanalogous to that performed by a bank withsimilar lending services. The process should beindependent of the FCM’s marketing, sales, andfinancing functions but may be performed by theFCM’s banking affiliate. Examiners should deter-mine how customer-financing decisions are madeand confirm that documentation is adequate,even when an affiliate approves the financing. In

addition, the FCM should review financialinformation on its customers periodically andadjust lending limits when appropriate.

Clearing-Only Risk

FCMs often enter into agreements to clear, butnot execute, trades for customers. Under a‘‘clearing-only’’ arrangement, the customer givesits order directly to an executing FCM. Theexecuting FCM then gives the executed transac-tion to the clearing FCM, which is responsiblefor accepting and settling the transaction. Cus-tomers often prefer this arrangement because itprovides the benefits of centralized clearing(recordkeeping and margin payments) with theflexibility of using a number of specializedbrokers to execute transactions.

FCMs entering into clearing-only arrange-ments execute writtengive-upagreements, whichare triparty contracts that set forth the responsi-bilities of the clearing FCM, the executingFCM, and the customer. Most FCMs use theuniform give-up agreementprepared by theFutures Industry Association, although someFCMs still use their own give-up contracts. Theuniform give-up agreement permits a clearingFCM, upon giving prior notice to the customerand the executing FCM, to place limits orconditions on the transactions it will accept toclear or terminate the arrangement. If an executedtransaction exceeds specified limits, the FCMmay decline to clear the transaction unless it isacting as thequalifying or primary clearingFCM for the customer and has not given priornotice of termination, as discussed further below.

Clearing-only arrangements can present sig-nificant credit risks for an FCM. An FCM’srisk-management policies and procedures forclearing-only activities should address the quali-fications required of clearing-only customersand their volume of trading, the extent to whichcustomer-trading activities can be monitoredby the clearing-FCM at particular exchanges,and how aggregate risk will be measured andmanaged.

The FCM should establish trading limits foreach of its clearing-only customers and haveprocedures in place to monitor their intradaytrading exposures. The FCM should take appro-priate action to limit its liability if a clearing-only customer has exceeded acceptable tradinglimits either by reviewing and approving a limitexception or by rejecting the trade. Examiners

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should confirm that the FCM formally advises(usually in the give-up agreement) its customersand their executing FCMs of the trading param-eters established for the customer. Examinersshould also confirm that the FCM personnelresponsible for accepting or rejecting an executedtrade for clearance have sufficient current infor-mation to determine whether the trade is consis-tent with the customer’s trading limits. Give-upagreements (or other relevant documents such asthe customer account agreement) should permitthe FCM to adjust the customer’s transactionlimits when appropriate in light of market con-ditions or changes in the customer’s financialcondition.

Some FCMs act as the primary clearing firm(also referred to as the sponsoring or qualifyingfirm) for customers.10 A primary clearing firmguarantees to the clearinghouse that it willaccept and clearall trades submitted by thecustomer or executing FCM, even if the trade isoutside the agreed-on limits. Because an FCM isobligated to accept and clear all trades submittedby its primary clearing customers, the FCMmust be able to monitor its customers’ tradingactivities on an intraday basis for compliancewith agreed-on trading limits. Monitoring isespecially important during times of marketstress. The FCM should be ready and able totake immediate steps to address any unaccept-able risks that arise, for example, by contactingthe customer to obtain additional margin orother assurances, approving a limit exception,taking steps to liquidate open customer posi-tions, or giving appropriate notice of termina-tion of the clearing arrangement to enable theFCM to reject future transactions.

Intraday monitoring techniques will varydepending on the technology available at theparticular exchange. A number of the larger,more automated U.S. exchanges have developedtechnologies that permit multiple intraday col-lection, matching, and reporting of trades—although the frequency of such reconciliationsvaries. On exchanges that are less automated,the primary clearing FCM must develop proce-dures for monitoring clearing-only risks. For

example, the FCM could maintain a significantphysical presence on the trading floor to monitorcustomer trading activities and promote morefrequent collection (and tallying) of trade infor-mation from clearing-only customers. Theresources necessary for such monitoring obvi-ously will depend on the physical layout of theexchange—the size of the trading floor and thenumber of trading pits, the floor population anddaily trading volumes, and the level of familiar-ity the FCM has with the trading practices andobjectives of its primary clearing customers.The FCM should be able to increase its floorpresence in times of market stress.

Carrying-Broker Risk

An FCM may enter into an agreement withanother FCM to execute and clear transactionson behalf of the first FCM (typically, when thefirst FCM is not an exchange or clearing mem-ber of an exchange). In such cases, the FCMseeking another or carrying FCM to execute itstransactions should have procedures for review-ing the creditworthiness of the carrying FCM. Ifthe FCM reasonably expects that the carryingFCM will use yet another FCM to clear itstransactions (for example, if the carrying FCMenters into its own carrying-broker relationshipwith another firm for purposes of executing orclearing transactions on another exchange), thefirst FCM should try to obtain an indemnifica-tion from the carrying FCM for any lossesincurred on these transactions.11 When carryingtransactions occur on a foreign exchange, anFCM should know about the legal ramificationsof the carrying relationship under the rules ofthe exchange and laws of the host country.Moreover, it may be appropriate for an FCMto reach an agreement with its customers thataddresses liabilities relative to transactionseffected on a non-U.S. exchange by a carryingbroker.

Executing-FCM Risk

When an FCM uses an unaffiliated FCM toexecute customer transactions under a give-up

10. Primary clearing customers include institutions andindividuals, as well as other nonclearing futures professionals(locals or floor traders), who execute their own trades on theexchange and other nonclearing FCMs that execute trades forunaffiliated customers.

11. The CFTC takes the position that an FCM is respon-sible to its customers for losses arising from the failure of theperformance of a carrying broker. The industry disagrees withthis position, and the issue has not been resolved by the courts.

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arrangement, the clearing firm that sponsors theexecuting FCM guarantees its performance.Therefore, the first FCM should review thesubcontracting risk of its executing FCMs andtheir sponsoring clearing firms. However, unlikethe clearing risk inherent in a carrying-brokerrelationship, the subcontracting risk for an FCMusing an executing FCM is limited to transactionrisk (execution errors). An FCM’s managementshould approve each executing broker it uses,considering the broker’s reputation for obtainingtimely executions and the financial condition ofits sponsoring clearing firm.

Pit-Broker Risk

Usually, FCMs will subcontract the execution oftheir orders to unaffiliated pit brokers whoaccept and execute transactions for numerousFCMs during the trading day. The risk associ-ated with using a pit broker is similar to that ofusing an executing broker: the risk is limited tothe broker’s performance in completing thetransaction. If the pit broker fails, then theprimary clearing firm is responsible for complet-ing the transaction. Therefore, an FCM shouldapprove each pit broker it uses, considering thepit broker’s reputation for obtaining timelyexecutions and the resources of its sponsoringclearing firm.

Clearinghouse Risk

Clearinghouse risk is the potential that a clear-inghouse will require a member to meet loss-sharing assessments caused by another clearingmember’s failure. Before authorizing member-ship in an exchange or clearinghouse, an FCM’sboard of directors and its parent company mustfully understand the initial and ongoing regula-tory and financial requirements for members.The FCM’s board of directors should approvemembership in a clearinghouse only after athorough consideration of the financial condi-tion, settlement and default procedures, andloss-sharing requirements of the clearinghouse.

Particularly when it is considering member-ship in a foreign exchange or clearinghouse, anFCM’s board should examine any regulatoryand legal precedents related to how the exchange,clearinghouse, or host country views loss-sharing arrangements. As in the United States,

some foreign clearinghouses have unlimited loss-sharing requirements, and some have ‘‘limited’’requirements that are set at very high percent-ages. However, the loss-sharing provisions ofsome of the foreign clearinghouses have not yetbeen applied, which means that there are nolegal and regulatory precedents for applying thestated requirements. In addition, the board shouldbe apprised of any differences in how foreignaccounts are viewed, for example, whether cus-tomer funds are considered separate from thoseof the FCM, whether the relationship betweenan FCM and its customer is viewed as an agencyrather than a principal relationship, and whetherthere are material differences in the way futuresactivities are regulated.

The board also should be apprised of anymaterial changes in the financial condition ofevery clearinghouse of which the FCM is amember. Senior management should monitorthe financial condition of its clearinghouses aspart of its risk-management function.

Guarantees

FCM parent companies often are asked to pro-vide assurances to customers and clearinghousesthat warrant the FCM’s performance. Thesearrangements may take the form of formalguarantees or less formal letters of comfort.

Under Regulation Y, a bank holding companymay not provide a guarantee to a clearinghousefor the performance of the FCM’s customerobligations. A bank holding company may pro-vide a letter of comfort or other agreement to theFCM’s customers that states the parent (oraffiliate) will reimburse the customers’ funds ondeposit with the FCM if they are lost as a resultof the FCM’s failure or default. Customers mayseek this assurance to avoid losses that couldarise from credit exposure created by anothercustomer of the FCM, since the clearinghousemay use some or all of the FCM’s customer-segregated funds in the event of a default by theFCM stemming from a failing customer’s obli-gations.12 Examiners should note any permis-sible guarantees for purposes of the consolidatedreport of the parent bank holding company, as

12. The letter of comfort would protect customers whosefunds were used to cover other customer losses by theclearinghouse. U.S. clearinghouses also have guarantee fundsthat can be used to reimburse customers at the clearinghouse’sdiscretion.

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they are relevant to calculating the consolidatedrisk-based capital of the bank holding company.

Market Risk

When an FCM acts as a broker on behalf ofcustomers, it generally is only subject to marketrisk if it executes customers’ transactions inerror. In this regard, operational problems canexpose the FCM to market fluctuations in con-tract values. However, when an FCM engages inproprietary trading, such as market making andother position-taking, it will be directly exposedto market risk. Potential market-risk exposureshould be addressed appropriately in an FCM’spolicies and procedures.

An FCM that engages in proprietary tradingshould establish market-risk and trading param-eters approved by its parent company. TheFCM’s senior management should establish anindependent risk-management function to con-trol and monitor proprietary trading activities.Finally, the FCM should institute procedures tocontrol potential conflicts of interest between itsbrokerage and proprietary trading activities.

Liquidity Risk

Liquidity risk is the risk that the FCM will notbe able to meet its financial commitments (end-of-day and intraday margin calls) to its clearingFCM or clearinghouse. Clearing FCMs arerequired to establish an account at one of thesettlement banks used by the clearinghouse forits accounts and the accounts of its clearingmembers. In some foreign jurisdictions, thecentral bank fulfills this settlement function. AnFCM should establish and monitor daily settle-ment limits for its customers and should ensurethat there are back-up liquidity facilities to meetany unexpected shortfalls in same-day funds. Toensure the safety of its funds and assets, an FCMshould also monitor the financial condition ofthe settlement bank it has chosen and should beprepared to transfer its funds and assets toanother settlement bank, if necessary.

To control other types of liquidity risks, anFCM should adopt contingency plans for liquid-ity demands that may arise from dramatic mar-ket changes. An FCM, to the extent posible,should monitor the markets it trades in toidentify undue concentrations by others that

could create an illiquid market, thereby creatinga risk that the FCM could not liquidate itspositions. Most U.S. clearinghouses monitorconcentrations and will contact an FCM thatholds more than a certain percentage of the openinterest in a product. In some situations, theexchange could sanction or discipline the FCMif it finds that the FCM, by holding the undueconcentration, was attempting to manipulate themarket. These prudential safeguards may not bein place on foreign exchanges; consequently, anFCM will have to establish procedures to moni-tor its liquidity risk on those exchanges.

Reputation Risk

FCMs should have reporting procedures in placeto ensure that any material events that harm itsreputation, and the reputations of its bank affili-ates, are brought to the attention of seniormanagement; the FCM’s board of directors;and, when appropriate, its parent company.Reports of potentially damaging events shouldbe sent to senior management at the parent bankholding company who will evaluate their effecton the FCM to determine what, if any, stepsshould be taken to mitigate the impact of theevent on the whole organization.

Commodity Trading Advisor

Acting as a commodity trading advisor (includ-ing providing discretionary investment adviceto retail and institutional customers or commod-ity pools) may pose reputational and litigationrisks to a CTA or FCM, particularly when retailcustomers are involved. Accordingly, the FCM’sboard should adopt policies and proceduresaddressing compliance with CFTC and NFAsales-practice rules (including compliance withthe know-your-customer recordkeeping rules).

Operations Risk

Operations risk is the potential that deficienciesin information systems or internal controls willresult in unexpected loss. Some specific sourcesof operating risk at FCMs include inadequateprocedures, human error, system failure, or fraud.For FCMs, failure to assess or control operating

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risks accurately can be a likely source ofproblems.

Adequate internal controls are the first line ofdefense in controlling the operations risksinvolved in FCM activities. Internal controlsthat ensure the separation of duties involvingaccount acceptance, order receipt, execution,confirmation, margin processing, and account-ing are particularly important.

An FCM’s approved policies should specifydocumentation requirements for transactions andformal procedures for saving and safeguardingimportant documents, consistent with legalrequirements and internal policies. Relevant per-sonnel should fully understand documentationrequirements. Examiners should also considerthe extent to which institutions evaluate andcontrol operations risks through internal audits,contingency planning, and other managerial andanalytical techniques.

Back-office or transaction-processing opera-tions are an important source of operations-riskexposures. In conducting reviews of back-officeoperations, examiners should consult the appro-priate chapters of this manual for furtherguidance.

Operations risk also includes potential lossesfrom computer and communication systems thatare unable to handle the volume of FCM trans-actions, particularly in periods of market stress.FCMs should have procedures that address theoperations risks of these systems, includingcontingency plans to handle systems failuresand back-up facilities for critical parts of riskmanagement, communications, and accountingsystems.

When FCMs execute or clear transactions innonfinancial commodities, they may have totake delivery of a commodity because a cus-tomer is unable or unwilling to make or takedelivery on its contract. To address this situa-tion, the FCM should have in place the proce-dures it will follow to terminate its position andavoid dealing in physical commodities. Internalcontrols should also be established to record,track, and resolve errors and discrepancies withcustomers and other parties.

INTERNAL AUDITS

An FCM should be subject to regular internalaudits to confirm that it complies with its poli-cies and procedures and is managed in a safe

and sound manner. In addition, the internal-auditfunction should review any significant issuesraised by compliance personnel to ensure thatthey are resolved. Other staff within the FCMshould be able to reach internal audit staff todiscuss any serious concerns they might have.Internal audit reports should be forwarded tothe FCM’s senior management and materialfindings should be reported to the FCM’s boardof directors and the parent company. Frequently,the internal audit function is located at theparent company, and audit reports are routinelysent to senior management at the parentcompany.

EXAMINATION AND INSPECTIONPROCEDURES

The review of an FCM’s functions should takea functional regulatory approach, using thefindings of the FCM’s primary regulators asmuch as possible. Examiners should especiallyfocus on the risks that the FCM poses to theparent company and affiliated banks. Theserisks should be assessed by reviewing the ade-quacy of the FCM’s policies and procedures,internal controls, and risk-management func-tions. Compliance with policies and procedures,and with any conditions on the FCM’s activitiesimposed by regulatory authorities (includingthe Federal Reserve Board), should be fullyreviewed.

Bank holding companies, banks, and FBOsmay have more than one subsidiary that acts asan FCM in the United States or that engages infutures transactions for customers in foreignmarkets. To ensure that the FCM/CTA activitiesof a banking organization are evaluated on aconsolidated basis, a cross-section of affiliatedfutures brokerage and advisory firms should bereviewed periodically—particularly those thatpresent the greatest risk to the consolidatedfinancial organization. Relevant factors to con-sider when identifying firms for review include(1) the volume of business; (2) whether theFCM has unaffiliated customers; (3) the numberof customers; (4) whether the firm providescustomer financing; (5) the number of brokerseffecting transactions; (6) whether exchangeor clearinghouse memberships are involved;(7) whether the FCM provides clearing-onlyservices; and (8) the date and scope of the lastreview conducted by the Federal Reserve, SRO,or other regulator.

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The scope of any review to be conducteddepends on the size of the FCM and the scope ofits activities. The draft first-day letter shouldprovide an overview of an FCM’s authorizedactivities and conditions, as well as a descriptionof the actual scope of its business. Examinersshould review the most recent summary ofmanagement points or other inspection resultsissued by the FCM’s SRO or other regulator, aswell as any correspondence between the FCMand any federal agency or SRO. If examinersshould have any questions about the findings ofan SRO’s or a regulator’s results, they shouldcontact the organization to determine whetherthe matter is material and relevant to the currentinspection. The status of any matters left openafter the SRO’s or regulator’s review shouldalso be inquired about.

An important factor in determining the scopeof the inspection is whether the FCM hasunaffiliated customers or conducts transactionssolely for affiliates. Other factors include whetherthe FCM is a clearing member of an exchange,particularly of a non-U.S. exchange; it acts as acarrying broker on behalf of other FCMs; it hasomnibus accounts with other brokers in marketsin which it is not a member (U.S. or foreign); itprovides advisory or portfolio management ser-vices, including discretionary accounts, or hasbeen authorized to act as a commodity pooloperator (CPO); it provides clearing services tolocals or market-makers; and it provides financ-ing services to customers.13

Examiners are not expected to routinely per-form a front- or back-office inspection unless(1) the FCM’s primary regulator found materialdeficiencies in either office during its mostrecent examination or (2) if front- or back-officeoperations have not been examined by the pri-mary regulator within the last two years. How-ever, examiners may still choose to review asmall sample of accounts and transactions toconfirm that appropriate controls are in place. Inaddition, net capital computations of U.S. FCMsdo not need to be reviewed; they are reviewedby the FCM’s DSRO, and the FCM is subject

to reporting requirements if capital falls belowwarning levels. Examiners should perform afront- and back-office review of the FCM’soperations outside of the United States.14

Examiners may rely on well-documentedinternal-audit reports and workpapers to verifythe adequacy of risk management at the FCM. Ifan examiner finds that an internal audit ade-quately documents the FCM’s compliance witha policy or procedure pertaining to the manage-ment of the various risk assessments required bythe current inspection, he or she should docu-ment the audit finding in the workpapers andcomplete inspection procedures in any area notadequately addressed by the internal audit report.Examiners should periodically spot check areascovered by internal audits to ensure the ongoingintegrity of the audit process. Examiners shouldalso review internal-audit reports and work-papers for their scope and thoroughness incomplying with FCM policies and procedures.Finally, examiners should ensure that internalauditors have adequate training to evaluate theFCM’s compliance with its policies and proce-dures and with applicable laws and regulations(both inside and, if applicable, outside the UnitedStates).

If an examiner has determined that it is notnecessary to perform a routine back-officereview, he or she should confirm that the FCMhas addressed operations risks in its policies andprocedures. Examiners also should review theinternal controls of an FCM to ensure that thefirm is operated safely and soundly according toindustry standards and that it complies with anyBoard regulations or conditions placed on theFCM’s activities. Examiners should be alert toany ‘‘red flags’’ that might indicate inadequateinternal controls. An FCM must be organized sothat its sales, operations, and compliance func-tions are separate and managed independently.If an FCM engages in proprietary trading,examiners should confirm that the firm hasprocedures that protect against conflicts of inter-est in the handling of customer orders (examplesof these conflicts of interest include front-running or ex-pit transactions). To make anoverall assessment of the FCM’s future busi-ness, the results of any review should be con-solidated with the results of reviews by otherFCMs inspected during this cycle.

13. If the FCM engages in proprietary trading for its ownaccount, particularly for purposes other than hedging (marketmaking or position-taking), or if the FCM acts as an interme-diary in any over-the-counter futures or other derivativeactivities, the examiner should advise the examiner in chargeof the inspection so that the firm’s proprietary trading can beevaluated in connection with similar activities of the consoli-dated financial organization.

14. The inspection procedures for reviewing front- andback-office operations may be found in sections 2050.3 and2060.3, respectively.

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Futures Brokerage Activities andFutures Commission MerchantsExamination Objectives Section 3030.2

1. To identify the potential for and extent ofvarious risks associated with the FCM’sactivities, particularly credit, market, liquid-ity, operations, and reputation risks.

2. To evaluate the adequacy of the audit func-tion and review significant findings, themethod of follow-up, and management’sresponse to correct any deficiencies.

3. To assess the adequacy of the risk-management function at the FCM.

4. To assess the adequacy of and compliancewith the FCM’s policies and procedures andthe adequacy of the internal-control function.

5. To evaluate and determine the FCM’s levelof compliance with relevant Board regula-tions, orders, and policies.

6. To assess the adequacy of risk managementof affiliated FCMs on a consolidated basis.

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Futures Brokerage Activities andFutures Commission MerchantsExamination Procedures Section 3030.3

1. Identify all bank holding company subsidi-aries that engage in FCM- or CTA-typeactivities in the United States or abroad oridentify U.S. FCM or CTA subsidiaries ofFBOs. Determine which firms should beinspected to provide a global view ofthe adequacy of management of theseactivities on a consolidated basis, based onthe scope of activities and degree of super-vision by other regulators. Complete appli-cable procedures below for firms selectedfor inspection.

2. Review first-day letter documents; noticesfiled under Regulation Y; Board orders andletters authorizing activities; previousinspection reports and workpapers; and pre-vious audits by futures regulators (CFTC,designated self-regulatory organization(DSRO), National Futures Association, for-eign futures regulator); and reports by inter-nal or external auditors or consultants.

3. Note the scope of the FCM’s activities,including—a. execution and clearing;b. execution only for affiliates and third

parties;c. clearing only for affiliates, third parties,

professional floor traders (locals);d. pit brokerage;e. advisory;f. discretionary portfolio management;g. commodities pool operator (in an FCM

or affiliate);h. margin financing;i. proprietary trading;j. exchange market maker or specialist;k. types of instruments (financial, agricul-

tural, precious metals, petroleum);l. contract markets where business is

directed;m. other derivative products (interest rate

swaps and related derivative contracts,foreign-exchange derivative contracts,foreign government securities, andothers);

n. other futures-related activities, includingoff-exchange transactions;

o. riskless-principal transactions; andp. registered broker-dealers.

4. Review exchange and clearinghouse mem-berships here and abroad, noting any finan-

cial commitments and guarantees by theFCM or its parent to the exchange orclearinghouse with respect to proprietary,affiliate, or customer transactions.

5. Note any new lines of business or activitiesoccurring at the FCM or any changes toexchange and clearinghouse membershipssince the last inspection.

6. Note what percentage of business is con-ducted for—a. affiliate banks,b. nonbank affiliates,c. customers (note the breakdown between

institutional and retail, and any guaran-tee or letter of comfort to customers inwhich the parent company provides thatit will reimburse customers for loss as aresult of the FCM’s failure or otherdefault),

d. proprietary accounts (hedging, position-taking), and

e. professional floor traders (locals, marketmakers).

7. Determine the quality of the internal auditprogram. Assess the scope, frequency, andquality of the audit program for the FCMand related activities.a. Review the most recent audit report,

noting any exceptions and their resolution.b. Verify that audit findings have been com-

municated to senior management andthat material findings have been reportedto the FCM’s board of directors andparent company.

c. Identify any areas covered by these pro-cedures that are not adequately addressedby the internal audit report.

d. Identify areas of the internal audit reportthat should be verified as part of thecurrent inspection.

8. Determine the scope of review that isappropriate to the activities and allocateresources, considering the adequacy ofinternal audit workpapers. Complete appro-priate front- or back-office inspection pro-cedures if—a. front- and back-office operations have

not been examined by the designatedself-regulatory organization (DSRO)within the last two years,

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b. material deficiencies in front- or back-office operations were found by theDSRO during the most recent audit, or

c. the primary regulator for the FCM is nota U.S. entity.

9. Advise the examiner who is in charge ofinspection of the parent company if theFCM engages in proprietary trading or over-the-counter futures or derivative business asprincipal or agent.

BOARD AND SENIORMANAGEMENT OVERSIGHT

10. Review the background and experience ofthe FCM’s board of directors and seniormanagement, noting prior banking andfutures brokerage experience.

11. Determine if the board of directors of theFCM has approved written policies summa-rizing the firm’s activities and addressingoversight by the board or a board desig-nated committee of—a. the risk appropriate for the FCM, includ-

ing credit, market, liquidity, operations,reputation, and legal risk (see SR-95-51);

b. the monitoring of compliance with riskparameters;

c. exchange and clearinghouse member-ships; and

d. the internal audit function.12. Determine if senior management of the

FCM has adopted procedures implementingthe board’s policies for—a. approval of new-product lines and other

activities;b. transactions with affiliates;c. transactions by employees;d. compliance with applicable regulations,

policies, and procedures;e. management information reports;f. the separation of sales, operations, back-

office, and compliance functions; andg. reports to FCM boards of directors that

describe material findings of the com-plaint or audit functions and materialdeficiencies identified during the courseof regulatory audits or inspections.

13. Determine if policies and procedures areperiodically reviewed by the board of direc-tors or senior management, as appropriate,to ensure that they comply with existing

regulatory and supervisory standards andaddress all of the FCM’s activities.

14. Review management information reportingsystems and determine whether the board ofdirectors of the parent company (or a des-ignated committee of the parent’s board) isapprised of—a. material developments at the FCM;b. the financial position of the firm, includ-

ing significant credit exposures;c. the adequacy of risk management;d. material findings of the audit or compli-

ance functions; ore. material deficiencies identified during

the course of regulatory reviews orinspections.

15. Review the FCM’s strategic plan.a. Assess whether there are material incon-

sistencies between the stated plans andthe FCM’s stated risk tolerances.

b. Verify that the strategic plan is reviewedand updated periodically.

CREDIT RISK

16. Review credit-risk policies and procedures.a. Verify the independence of credit-review

approval from the limit-exceptionsapproval.

b. Verify that the procedures designate asenior officer who has responsibility tomonitor and approve limit-exceptionapprovals.

17. Determine whether the FCM has authorityto open customer accounts without parent-company approval.

18. Review the customer base (affiliates, thirdparties) for credit quality in terms of affili-ation and business activity (affiliates, cor-porate, retail, managed funds, floor traders).

19. Evaluate the process for customer-creditreview and approval. Determine whethercustomer-credit review identifies credit risksassociated with the volume of transactionsexecuted or cleared for the customer.

20. Evaluate the adequacy of credit-risk-management policies. Determine that they—a. establish credit limits for each customer

that reflect the respective financialstrengths, liquidity, trading objectives,and potential market risk associated withthe products traded,

b. require periodic updates of such creditlimits in light of changes in the financial

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condition of each customer and marketconditions, and

c. do not permit the FCM to waive impor-tant broker safeguards, such as the rightto liquidate customer positions upondefault or late payment of margin.

21. Verify this information by sampling cus-tomer credit files.

22. Verify that up-to-date customer credit filesare maintained on site or are available forreview during the inspection. If the cus-tomer credit approval was performed by theparent company or an affiliate bank, verifythat the FCM’s files contain informationindicating the scope of the credit review, theapproval, and credit limits.

23. Review notifications and approval of limitexceptions for compliance with FCMprocedures.

24. Determine whether the FCM has adoptedprocedures identifying when the FCMshould take steps to limit its customer creditexposure (for example, when to refuse atrade, grant a limit exception, transfer posi-tions to another FCM, or liquidate customerpositions).

25. Evaluate the adequacy of risk managementof customer-financing activities.a. Determine that the credit-review process

is independent from the marketing andsales and financing functions.

b. Verify that the FCM has policies thatidentify customer-credit standards andestablish overall lending limits for eachcustomer.

c. Assess the adequacy of the credit-reviewprocess and its documentation, even whencredit review is performed by an affiliate.

26. Review the instances when the FCM haslent margin to customers on an unsecuredbasis. If the FCM does not engage in marginfinancing as a business line, verify thatextensions are short term and within theoperational threshold set for the customer.

CLEARING-ONLY RISK

27. Determine whether each clearing arrange-ment is in writing and that it—a. identifies the customer and executing

brokers, and defines the respective rightsand obligations of each party;

b. establishes overall limits for the cus-tomer that are based on the customer’s

creditworthiness and trading objectives;and

c. permits transaction limits to be adjustedto accommodate market conditions orchanges in the customer’s financialcondition.

28. When the FCM has entered into a clearing-only agreement with a customer, verify thatit has reviewed the creditworthiness of eachexecuting broker or its qualifying clearingfirm identified in the agreement.

29. If the FCM acts as the primary clearing firmfor locals or other customers, confirm thatthe firm has adopted procedures for moni-toring and controlling exposure. Notewhether the firm monitors customer posi-tions throughout the trading day and howthis monitoring is accomplished.

CARRYING BROKERS,EXECUTING BROKERS, AND PITBROKERS

30. If the FCM uses other brokers to execute orclear transactions, either on an omnibus or afully disclosed basis, determine that it hasadequately reviewed the creditworthinessand approved the use of the other brokers. Ifthe FCM uses nonaffiliated executing bro-kers, confirm that it also has considered thereputation of the broker’s primary clearingfirm. If the other broker is likely to useanother broker, determine whether the bro-ker has given the FCM an indemnificationagainst any loss that results from the per-formance or failure of the other broker.

31. If the FCM uses other brokers to execute orclear transactions in non-U.S. markets, deter-mine whether senior management under-stands the legal risks pertinent to doingbusiness in those markets and has adoptedpolicies for managing those risks.

32. When the FCM utilizes third-party ‘‘pitbrokers’’ to execute transactions, verify thatthe FCM has reviewed and approved eachbroker after considering the reputation ofthe pit broker’s primary clearing firm.

EXCHANGE ANDCLEARINGHOUSE MEMBERSHIP

33. Verify that the FCM completes a due dili-gence study of each exchange and clearing-

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house before applying for membership inthe organization.a. Determine whether board minutes

approving membership demonstrate athorough understanding of the loss-assessment provisions and other obliga-tions of membership for each exchangeand clearinghouse, as well as a generalunderstanding of the regulatory scheme.

b. Determine whether, in approving mem-bership in a non-U.S. exchange or clear-inghouse, the minutes indicate a discus-sion of the regulatory environment andany relevant credit, liquidity, and legalrisks associated with doing business inthe particular jurisdiction. Minutes alsoshould reflect discussion of any materialdifferences from U.S. precedent in howforeign accounts are viewed. For exam-ple, are customer funds held in anomnibus account considered separate(segregated) from those of the FCM, oris the relationship between the FCMand its customers viewed as an agencyor principal relationship in the hostcountry?

34. Verify that the FCM has apprised its parentcompany of the results of its study of theexchange or clearinghouse and that it haswritten authorization from the senior man-agement of its parent company to apply formembership.

35. Verify that the FCM monitors the financialcondition of each exchange and clearingorganization for which it is a member.

36. Review all guarantees, letters of comfort, orother forms of potential contingent liability.Verify that the parent company has notprovided a guarantee to the clearinghousefor the performance of the FCM’s customerobligations. Note any guarantees againstlosses the parent bank holding companyincurred from the failure of the FCM andadvise the examiner who is in charge of theparent company’s examination, who canconfirm that guarantees are included in thebank holding company’s calculation of con-solidated risk-based capital.

MARKET RISK

37. If an FCM engages in proprietary trading,determine whether policies and procedures

are in place to control potential conflicts ofinterest between its brokerage business andtrading activities.

LIQUIDITY RISK

38. Verify that the FCM has established andmonitors daily settlement limits for eachcustomer to ensure that its liquidity is suf-ficient to meet clearinghouse obligations.

39. Determine whether the FCM has estab-lished back-up liquidity facilities to meetunexpected shortfalls.

40. Verify that the FCM monitors by productthe amount of open interest (concentrations)that it, holds at each exchange either directlyor indirectly through other brokers. If posi-tions are held on foreign exchanges inwhich concentrations are not monitored,verify that the FCM is able to monitor itspositions and manage its potential liquidityrisks arising from that market.

41. Review liquidity contingency plans for deal-ing with dramatic market changes.

REPUTATION RISK

42. Review management information reportingsystems to determine whether the FCM isable to assess the extent of any materialexposure to legal or reputation risk arisingfrom its activities.

43. Review management information reportingsystems to determine whether the parentcompany receives sufficient informationfrom the FCM to assess the extent of anymaterial exposure to litigation or reputationrisk arising from the FCM’s activities.

44. If the FCM provides investment advice tocustomers or commodities pools, determinewhether it has procedures designed to mini-mize the risks associated with advisoryactivities. Procedures might address thedelivery of risk disclosures to customers,the types of transactions and trading strate-gies that could be recommended or effectedfor retail customers, compliance with theknow-your-customer recordkeeping andother sales practice rules of the SROs, andconformance to any trading objectivesestablished by the customer or fund.

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45. If the FCM acts as a commodities pooloperator, verify that it has obtained priorBoard approval and is in compliance withany conditions contained in the Board order.

OPERATIONS, INTERNALCONTROLS, AND COMPLIANCE

46. Review the most recent summary of man-agement points or similar document issuedby the FCM’s DSRO or other primaryfutures regulator. Discuss any criticism withFCM management and confirm that correc-tive action has been taken.

47. Review the organizational structure andreporting lines within the FCM, and verifyseparation of sales, trading, operations, com-pliance, and audit functions.

48. Determine that FCM policies and proce-dures address the booking of transactionsby affiliates and employees and other poten-tial conflicts of interest.

49. If the FCM is authorized to act as a com-modity pool operator, review the most recentNFA or other primary futures regulator’saudit, including any informal findings byexaminers. Discuss any criticism with FCMmanagement and confirm that correctiveaction has been taken.

50. If the FCM executes and clears nonfinancialfutures, verify that it has procedures toavoid taking physical possession of thenonfinancial product when effecting

‘‘exchange for physical transactions’’ forcustomers.

51. When the FCM takes physical delivery ofcommodities due to the failure or unwilling-ness of a customer to make or take deliveryof its contracts, determine whether the FCMhas and follows procedures to close out itsposition. Note if the FCM frequently takesdelivery of physical commodities.

52. Assess the adequacy of customer-complaintreview by reviewing the complaint file andhow complaints are resolved. Note if theFCM receives repeat or multiple complaintsinvolving one or more of its activities oremployees.

53. Determine whether the FCM has developedcontingency plans that describe actions tobe taken in times of market disruptions andwhether plans address management respon-sibilities including communications with itsparent bank holding company, liquidity, theeffect on customer credit quality, and com-munications with customers.

CONCLUSIONS

54. Prepare inspection findings and draw con-clusions on the adequacy of the FCM’srisk-management, compliance, operations,internal controls, and audit functions.

55. Present findings to FCM management andsubmit inspection findings to the examinerwho is in charge of the parent company’sinspection.

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Equity Investment and Merchant Banking ActivitiesSection 3040.1

INTRODUCTION

Equity investment activities have had a signifi-cant impact on earnings and business relation-ships at a number of banking organizations. TheGramm-Leach-Bliley Act (GLB Act), enactedin November 1999, enhanced the potentialgrowth of equity investment activities, as wellas the potential for institutions new to theequity-investing business to undertake theseactivities. The merchant banking provisions ofthe GLB Act authorized financial holding com-panies (FHCs) to make investments, in anyamount, in the shares, assets, or ownershipinterests of any type of nonfinancial company.While equity-investing activities can contributesubstantially to earnings when market condi-tions are favorable, they can entail significantmarket, liquidity, and other risks and give rise toincreased volatility of earnings and capital.Accordingly, sound investment- and risk-management practices are critical to success-fully conducting equity investment activities inbanking organizations.

This section provides a supervisory frame-work and examination procedures for reviewingthe soundness of the investment-managementand risk-management techniques used to con-duct equity investment activities. Guidance onevaluating the impact of these activities on therisk profile and financial condition of the bank-ing organization is included. The section incor-porates and expands on guidance on soundpractices for managing the risk of equity invest-ments that was provided in SR-00-9, issued onJune 22, 2000.

Goals of Supervision

As in the examination or review of any financialactivity that a banking organization conducts,the supervisory assessment of equity investmentactivities should be risk-focused and structuredto identify material risks to the safety andsoundness of the depository institution that isconducting the activity, or to identify risks thatare attributable to affiliates of FHCs and bankholding companies (BHCs) engaged in thesebusiness lines. Consistent with the FederalReserve’s role as umbrella supervisor of FHCsand BHCs, examiners should, where appropriateand available, use the findings of primary bank

supervisors and functional regulators of holdingcompany affiliates in reviewing the potentialrisks of equity investment activities. The super-visory assessment should include a review of thebanking organization’s compliance with the laws,regulations, and supervisory guidance applica-ble to this business line. (See ‘‘Compliance withLaws and Regulations’’ below.)

TYPES OF EQUITYINVESTMENTS

Banking organizations may make a variety ofequity investments with different characteristicsand risk profiles, under different regulatoryauthorities. Equity investments may provideseed or early-stage investment funds to start-upcompanies, or they may finance changes inownership, middle-market business expansions,and mergers and acquisitions. Alternatively,banking organizations may hold interests inmature companies for long-term investment.

Equity investments may be in publicly tradedsecurities or privately held equity interests. Theinvestment may be made as a direct investmentin a specific portfolio company or may be madeindirectly through a pooled investment vehicle,such as a private equity fund. In general, privateequity funds are investment companies, typi-cally organized as limited partnerships, that poolcapital from third-party investors to invest inshares, assets, and ownership interests in com-panies for resale or other disposition.

Direct investment holdings can be in the formof common stock, preferred stock, convertiblesecurities, and options or warrants to purchasethe stock of a particular portfolio company.Direct equity investors often play an active rolein the strategic direction (but not the day-to-daymanagement) of the portfolio company, typi-cally through board representation or boardvisitation rights.

A banking organization may make indirectequity investments by acquiring equity interestsin either a single company or a portfolio ofdifferent companies as a partner in a limitedpartnership. Indirect investments are typicallymade in the form of commitments to limitedpartnership funds; these commitments are fundedwhen capital calls are made by the fund’sgeneral partner (or partners). The liquidity of

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indirect fund investments may be more con-stricted since fund managers may limit inves-tors’ ability to sell investments. However, thesefund investments often provide the advantagesof increased diversification.

Indirect ownership interests can also be madethrough limited partnerships that in turn holdonly ownership interests in other limited part-nerships of equity investments. Such tiered part-nership entities are often termed ‘‘funds offunds.’’ Fund-of-funds investments are profes-sionally managed limited partnerships that poolthe capital of investors for investment in otherequity investment limited partnerships. Whilefund-of-funds investments may generally involvehigh administrative costs, they also have thebenefit of providing generally high levels ofdiversification.

A banking organization can act as the generalpartner or manager of a limited partnership fund.As the general partner of a fund, the bankingorganization earns management fees and a per-centage of the earnings of the fund, often termed‘‘carried interest.’’ Management fees can rangebetween 1.5 percent and 2.5 percent of fund netasset value (NAV) or committed capital, andthese fees may decline in later years of thepartnership as investments mature. Carried inter-est, generally ranging from 20 percent to 25 per-cent of earnings, is the general partner’s share ofthe fund profits.

Banking organizations may offer fund invest-ments as an asset-management product to highnet worth private-banking and institutional cli-ents. Fund investments provide private-bankingand institutional investors with access to invest-ments that they may not otherwise have accessto because of minimum investment size andmarketing restrictions. However, securities lawsand regulations may apply to these sales, andbanks engaged in sales of fund investments tocustomers should establish a comprehensivesecurities law compliance program. (See ‘‘OtherLaws and Regulations’’ at ‘‘Compliance withLaws and Regulations’’ below.) In addition,when a banking organization acts as a generalpartner of a limited partnership fund, it musthave adequate operational and system supportcapabilities in place. System support capabilitiesmay be established internally or outsourced.

ACCOUNTING AND VALUATION

The accounting for and valuation of equity

investments can be varied and complex. Thesupervisory review of accounting and valuationmethodologies is critical, as the methodologyused can have a significant impact on the earn-ings and earnings volatility of the bankingorganization. For some equity investments, valu-ation can be more of an art than a science. Manyequity investments are made in privately heldcompanies, for which independent price quota-tions are either unavailable or not available insufficient volume to provide meaningful liquid-ity or a market valuation. Valuations of someequity investments may involve a high degree ofjudgment on the part of management or mayinvolve the skillful use of peer comparisons.Similar circumstances may exist for publiclytraded securities that are thinly traded or subjectto resale and holding-period restrictions or whenthe institution holds a significant block of acompany’s shares.

Accordingly, clearly articulated policies andprocedures on the accounting and valuationmethodologies used for equity investments areof paramount importance. Formal valuation poli-cies that specify appropriate and sound portfolio-valuation methodologies should be establishedfor investments in public companies; directprivate investments; indirect fund investments;and, where appropriate and to the extent pos-sible, other types of investments with specialcharacteristics. Portfolio-valuation methodolo-gies should conform to generally acceptedaccounting principles (GAAP) and be based onsound, empirically based approaches that areclearly articulated, well documented, and appliedconsistently across similar investments over time.

Accounting Methods

Several methods are used in accounting forequity investments. The key methods are(1) mark-to-market accounting, (2) available-for-sale (AFS) accounting, (3) cost-basis account-ing, and (4) equity-method accounting.

Mark-to-Market Accounting

Under GAAP, equity investments held by invest-ment companies or broker-dealers, as well assecurities held in the trading account, arereported at fair value, with any unrealized appre-ciation or depreciation included in earnings and

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flowing to tier 1 capital. Securities for whichmarket quotations are readily available are val-ued at prevailing closing prices derived frommarket-pricing sources or at an average marketprice. Banking organizations that employ aver-age price ranges typically do so for varyingperiods after the initial public offering (IPO) forissues in more volatile sectors, such as technol-ogy, media, and telecommunications. Mostinstitutions revert to closing prices after an issueis seasoned.

When the resale or transfer of securities is notrestricted, current market value is the quotedmarket price. Some publicly traded securitiesmay not be freely liquidated because of securi-ties law restrictions, underwriting lock-up pro-visions, or significant concentrations of hold-ings. The market value of restricted securitiesmust be determined in good faith by the board ofdirectors, taking into account factors such as(1) the fundamental analytical data relating tothe investment, (2) the nature and duration ofrestrictions on disposition of the securities, and(3) an evaluation of the forces that influence themarket in which the securities are purchased andsold.1

Liquidity discounts generally are applied torestricted holdings, based on the severity of therestrictions and the estimated period of time theinvestment must be held before it can be liqui-dated. Regardless of the method used, discountsshould be consistently applied. Changes in dis-count rates should generally be based on objec-tive and verifiable transactions or events.

While most banking organizations employ anobjective approach for identifying appropriatediscounts when specific discounts are applied toa given set of parameters, a limited number haveadopted a model-driven approach. The model-driven approach considers the marketability dis-count as the value of a put option based onassumptions about volatility, trading volumes,market absorption, and interest rates.

The marketability discount increases as thelength of the restriction period and the volatilityof the share price increase. Discount ranges

suggested by the model are reviewed for overallreasonableness and to evaluate additional fac-tors not considered by the model, such asproprietary information, historical discount rates,hedging or exit opportunities, and other empiri-cal data.

A banking organization using a model-drivenapproach should have policies and proceduresthat clearly specify the instruments for whichthe model is appropriate and should provideguidance for appropriate use of the model.Banking organizations that use models shouldmaintain comprehensive written documentationof the assumptions, methodologies, and quanti-tative and qualitative factors contained in themodel. Independent reviews of models shouldbe conducted periodically to verify model inputsand results. (See ‘‘Valuation Reviews’’ below.)

Available-for-Sale Accounting

Equity investments (1) not held with the intentto hold to maturity or (2) held in the tradingaccount that have a readily determinable fairvalue (quoted market value) are generallyreported as available-for-sale (AFS). They aremarked to market with unrealized appreciationor depreciation recognized in a separate compo-nent of equity (other comprehensive income),but not earnings. Appreciation or depreciationflows to equity, but for regulatory capital pur-poses only, depreciation is included in tier 1capital. Under regulatory capital rules, tier 2capital may include up to 45 percent of theunrealized appreciation of AFS equity invest-ments with readily determinable fair values.

Under Statement of Financial AccountingStandards No. 115 (FAS 115), a firm mustdetermine whether any decline in fair valuebelow the cost basis of an equity investmentheld AFS is ‘‘other than temporary.’’ If thedecline in fair value is judged to be other thantemporary, the cost basis of the individual secu-rity must be written down to fair value toestablish a new cost basis. The amount of thewrite-down must be charged against earnings.The new cost basis remains unchanged forsubsequent fair-value recoveries.

Increases in the fair value of AFS securitiesafter the purchase date are included in othercomprehensive income. Subsequent decreasesin fair value, if not an other-than-temporaryimpairment, are also included in other compre-hensive income. SEC Staff Accounting Bulletin

1. More specific factors may include the type of security,the financial condition of the company, the cost of thesecurities at the date of purchase, the size of the holding, thediscount from market value of unrestricted securities of thesame class at the time of purchase, special reports prepared byanalysts, information about any transactions or offers on thesecurity, the existence of merger proposals or tender offersaffecting the security, the price and extent of public trading insimilar securities of the issuer or comparable companies, andother relevant matters.

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(SAB) 59 specifies that declines in the valuationof marketable investment securities of SEC-registered companies caused by general marketconditions or by specific information pertainingto an industry or individual company shouldcause management to consider all evidence toevaluate the realizable value of the investment.Under SAB 59, SEC-registered companies areexpected to employ a systematic methodologythat documents all of the factors, in addition toimpairment, considered in valuing the security.These factors include the length of time andextent to which the market value has been lessthan cost, the financial condition and near-termprospects of the issuer, and the intent and abilityof the holder to retain the investment for aperiod of time sufficient to allow for any antici-pated market-value recovery.

It is a sound practice for banking organiza-tions to clearly articulate events, criteria, orconditions that trigger an other-than-temporaryimpairment of value. Examples of criteria thatmay indicate other-than-temporary impairmentof value include—

• a business model that is no longer viable;• a material internal risk-rating decline;• sustained cash flow or financial-performance

problems (for more than one year);• a dilutive subsequent private equity round of

financing;• major loan-provision defaults;• management, customer, and competitive

changes;• a debt restructuring; and• a material, adverse industry change.

Cost-Basis Accounting

For equity investments without readily determin-able fair values, including many privately heldcompanies, fair value generally is the cost of theinvestment, adjusted for write-downs reflectingsubsequent impairments to the value of theassets. Periodic evaluations of the valuation areperformed to confirm or reestablish fair valuebased on one or a combination of the followingevents or factors:

• a subsequent, significant round of financing inwhich a majority of the new funding is pro-vided by unrelated, sophisticated investors,and the new securities issued are similar to thetypes and classes of existing shares held

• a recent IPO of the company• a binding offer to purchase the company• a transaction involving the sale of a compa-

rable company• comparable information on publicly traded

companies that is based on meaningful indus-try statistics, such as multiples or earnings-performance ratios, and that takes into accountappropriate liquidity or restricted-securitydiscounts

• if comparable information for the public mar-ket is not available or relevant, private trans-actions involving comparable companies orindices of small-cap companies could providebenchmarks for valuation purposes

• net asset or liquidation values• company-specific developments indicating an

other-than-temporary impairment in the valueof the investment

• market developments

Valuations of equity investments are highlyaffected by assumed and actual exit strategies.The principal means of exiting an equity invest-ment in a privately held company include initialpublic stock offerings, sales to other investors,and share repurchases. An institution’s assump-tions regarding exit strategies can significantlyaffect the valuation of the investment. Theimportance of reasonable and comprehensiveprimary and contingent exit, or take-out, strate-gies for equity investments should be empha-sized. Secondary-market sales typically are madeat a discount. A secondary sale of a limitedpartnership interest generally needs to beapproved by the general partner or a percentageof the limited partners. Management shouldperiodically review investment-exit strategies,with particular focus on larger or less-liquidinvestments. Policies and procedures should beestablished to govern the sale, exchange, trans-fer, or other disposition of the institution’sinvestments. These policies and proceduresshould state clearly the level of management orboard approval required for the disposition ofinvestments. In the case of investments heldunder the merchant banking provisions of theGLB Act, policies and procedures should takeinto account the time limits for holding mer-chant banking investments, as specified in therules and regulations of the Board and theDepartment of the Treasury.

In addition, a discounted cash-flow approachmay be used to value private portfolio compa-nies with operating revenue. This approach to

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valuation estimates the value of the stream offuture cash flows expected to be realized fromthe investment. The application of appropriatemultiples and discounts should be well docu-mented and reasonably similar to industry datafor comparable companies. Any differences fromindustry data should be explicitly rationalized.

The valuation of private investment fundcompanies and private investment companies isbased on fair value as determined by the generalpartner, or the valuation is developed internallythrough financial information produced by thegeneral partner. Each portfolio company pre-pares financial statements, which are used tovalue the investments within the fund. Mostfinancial statements are audited annually byindependent auditors who express an opinion onthe fair-value methodology of the limited part-nership, in accordance with GAAP. Auditors’opinions are typically qualified. Private invest-ment companies maintain capital accounts thatreflect their proportional ownership in each fundand that are reconciled periodically (not lessthan annually) to fund financial statements.Write-downs are appropriate when this recon-ciliation process indicates unrealized losses inthe fund.

Many banking organizations adjust the valuereported by the general partner to account formanagement fees and carried interest, as well asliquidity discounts. Other banking organizationscarry their investments in limited partnershipfunds at cost and write down investments torecognize other-than-temporary impairments invalue below the cost basis.

Equity-Method Accounting

For investments in which the banking organiza-tion holds an ownership interest of between 20and 50 percent, or for investments that aremanaged or significantly influenced by the bank-ing organization, the equity method of account-ing is appropriate. A banking organization usingthe equity method initially records an invest-ment at cost. Subsequently, the carrying amountof the investment is increased to reflect thebanking organization’s share of the company’sincome and is reduced to reflect the organiza-tion’s share of the company’s losses or fordividends received from the company. The bank-ing organization also records its share of theother comprehensive income of the companyand adjusts its investment by an equal amount.

A loss in the value of an investment that is another-than-temporary decline is recognized. Inapplying the equity method, a banking organi-zation’s share of losses may equal or exceed thecarrying value of the investment plus advancesmade by the institution. The banking organiza-tion ordinarily should discontinue applying theequity method when the investments (and netadvances) have been reduced to zero and shouldnot provide for additional losses, unless thebanking organization has guaranteed obligationsof the company or is otherwise committed toprovide further financial support. A bankingorganization should, however, provide for addi-tional losses when the company appears to bepositioned for an imminent return to profitabil-ity. For example, a company may incur a mate-rial, nonrecurring loss that may reduce thebanking organization’s investment below zeroeven though the underlying profitable pattern ofthe company is unimpaired. If the companysubsequently reports net income, the bankingorganization should resume applying the equitymethod only after its share of the net incomeequals the share of the net losses not recognizedduring the period when the use of the equitymethod was suspended.

Valuation Reviews

Large complex banking institutions with mate-rial equity investment activities should haveperiodic independent reviews of their invest-ment process and valuation methodologies byinternal auditors or independent outside parties.In smaller, less complex institutions with imma-terial equity holdings and in which limitedresources may preclude independent review,alternative checks and balances may be estab-lished. In general, a banking organization shouldconduct valuation reviews semiannually. How-ever, an immediate review should be initiated ifdeterioration in the value of an investment isidentified. Valuation reviews should be docu-mented in writing and readily available forexaminer or auditor review. Examiners shouldreview the frequency, scope, and findings ofaudits or reviews to determine whether they arecommensurate with the size and complexity ofthe banking organization’s equity-investingactivities.

The two major components used to measureearnings, net income to assets (ROA) and net

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income to equity (ROE), generally are not usedas a performance measurement for equity invest-ments. ROA and ROE indicate the extent towhich invested capital increased in value, but donot reflect how long it took the increase to occur.In addition, the volatility of earnings fromequity investments makes net income-based mea-sures a less reliable indicator.

The standard method of measuring the per-formance of private equity investments is theinternal rate of return (IRR). The use of IRR hasone major advantage over traditional profitabil-ity measurement tools: it incorporates assump-tions about both reinvestment and the time valueof money, thereby providing a more accuratemeasure of performance. IRR measures both thedegree to which invested capital increases invalue and the time it takes for the increase tooccur. While increases in invested capital con-tribute to a higher IRR, the effect of the time isinversely related to IRR. Thus, the shorter thetime for an increase to occur, the higher the IRR.

IRR is determined by a process of trial anderror. When net present values of the cashoutflows (the cost of the investment) and cashinflows (returns on the investment) equal zero,the discount rate used is the IRR. When IRR isgreater than the required return, or the ‘‘hurdlerate,’’ the investment is considered acceptable.In other words, an IRR can be thought of as ayield to maturity. The longer an investmentexists in an illiquid portfolio, the greater itsappreciation must be to maintain a high IRR.

COMPLIANCE WITH LAWS ANDREGULATIONS

In conducting equity investment and merchantbanking activities, banking organizations shouldensure compliance with the laws and regulationsunder which investments are made. Investmentsmade under different laws and regulations maybe subject to very different guidelines andlimitations.

The board of directors and senior manage-ment of the banking organization should estab-lish a compliance function that is commensuratewith the complexity and risks of the equityinvestment activities the institution conducts. Ifthe compliance function for the equity invest-ment business line is decentralized, appropriatemechanisms should be in place to coordinate theequity investment compliance function with the

corporate-wide compliance function. Compli-ance reports should be furnished to the boardand senior management on a periodic basis andin a timely manner. The frequency and contentof these reports necessarily depends on thecomplexity and risk of the institution’s activities.

Investment Authorities

BHCs, FHCs, and depository institutions arepermitted to make direct and indirect equityinvestments under various statutory and regula-tory authorities. The form and nature of equityinvestments are subject to the provisions of lawand regulations that govern specific types ofinvestments.

Bank Holding Companies andRegulation Y

Under section 4(c) of the Bank Holding Com-pany Act (BHC Act), Congress exempted alimited number of investments from the generalprohibition against bank holding companies’owning or controlling shares of nonbankingcompanies. Section 4(c)(6) of the BHC Actauthorizes ownership or control of 5 percent orless of the outstanding voting shares of any onecompany. The Board has interpreted section4(c)(6) to authorize only noncontrolling invest-ments. In this regard, the Board has indicatedthat a BHC cannot own or control 25 percent ormore of the total equity of a company undersection 4(c)(6). In addition, section 4(c)(7) ofthe BHC Act authorizes ownership or control ofall of the shares of an investment company thatrestricts its investments to those permissibleunder section 4(c)(6).

Small Business Investment Companies

The Small Business Investment Act and section4(c)(5) of the BHC Act permit bank holdingcompanies and banks to make equity invest-ments through small business investment com-panies (SBICs), which may be subsidiaries ofbanks or bank holding companies. Congressauthorized the creation of SBICs to provide debtand equity financing to small businesses in theUnited States. SBICs are licensed and regulatedby the Small Business Administration (SBA).

SBIC activities are subject to the followingguidelines:

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• An SBIC generally is permitted to own up to49.9 percent of the outstanding voting sharesof a portfolio company.

• An SBIC generally is not permitted to exer-cise control over the portfolio company. How-ever, a presumption of control may be rebut-ted when the portfolio company’s managementowns at least 25 percent of the voting securi-ties and can elect at least 40 percent of thedirectors and when the SBIC investor groupcannot elect more than 40 percent of thedirectors. Moreover, temporary control maybe permitted in certain circumstances, such asa material breach of the financing agreementby the portfolio company or a substantialchange in the operations or products of theportfolio company.

• Portfolio companies must meet specific SBAcriteria, which define a small business.

• Aggregate investment in the stock of SBICs islimited to 5 percent of the bank’s capital andsurplus or, in the case of a bank holdingcompany, 5 percent of the bank holding com-pany’s proportionate interest in the capital andsurplus of its subsidiary banks.

If the SBIC takes temporary control of a smallbusiness, a control certification (a divestitureplan) must be filed with the SBA within 30 days.The certification must state the date on whichthe control was taken and the basis for takingcontrol.

Portfolio companies must meet the SBA defi-nition of a small business, which requires that(1) the business be independently owned andoperated, (2) the business not be dominant in itsfield of operation, and (3) the business meetseither of the two SBA methods of determiningcompliance with its size and income limitations.Under the first method, a business, together withits affiliates, must have a consolidated net worthof less than $18 million and after-tax income ofless than $6 million. The second method appliesnumber-of-employee and revenue limits to thebusiness based on standards set by the SBA forthe particular industry.

There are also restrictions on the type ofbusinesses in which an SBIC can invest: Invest-ments cannot be made in offshore companies.SBICs may not provide financing to a smallbusiness that engages in re-lending or re-investingactivities. At the time of the investment orwithin one year thereafter, no more than 49 per-cent of the employees or tangible assets of the

business can be located outside of the UnitedStates.

Edge Corporations and Regulation K

Regulation K implements sections 25 and 25Aof the Federal Reserve Act, which authorizebanking organizations to invest in Edge corpo-rations. One power of an Edge corporation is theability to make investments in foreign portfoliocompanies, subject to the following limitations:

• Ownership may not exceed 19.9 percent of theportfolio company’s voting equity or 40 per-cent of the portfolio company’s total equity.

• The aggregate level of portfolio investmentsmay not exceed 25 percent of the BHC’s tier1 capital. For state member banks, the relevantlimitation is 20 percent of tier 1 capital.

• Investments may be made under the Board’sgeneral-consent provisions (which do notrequire prior notice or approval) if the totalamount invested does not exceed the greaterof $25 million or 1 percent of the tier 1 capitalof the investor.

As a general rule, Edge corporations are prohib-ited from investing in foreign companies thatengage in the general business of buying orselling goods, wares, merchandise, or commodi-ties in the United States. In addition, an Edgecorporation is limited to a 5 percent interest inthe shares of a foreign company that engagesdirectly or indirectly in business in the UnitedStates that is impermissible for an Edgecorporation.

With Board approval, Edge corporations canhold investments in foreign companies that dobusiness in the United States if (1) the foreigncompany is engaged predominantly in businessoutside the United States or in internationallyrelated activities in the United States, (2) thedirect or indirect activities of the foreign com-pany in the United States are either banking orclosely related to banking, and (3) the U.S.banking organization does not own 25 percentor more of the voting stock or otherwise controlthe foreign company.

Section 24 of the Federal DepositInsurance Act

Section 24 of the Federal Deposit Insurance Act

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(FDI Act) governs the equity investments madeby insured state nonmember banks and gener-ally prohibits such investments unless the equityinvestment is permissible for a national bank.Section 24(f) of the FDI Act permits state banksto retain equity investments in nonfinancialcompanies if the investments are made pursuantto state law under certain circumstances. Otherprovisions of section 24 of the FDI Act permit astate bank to hold equity investments in nonfi-nancial companies if the FDIC determines thatthe investment does not pose a significant risk tothe deposit insurance fund.

Merchant Banking and theGramm-Leach-Bliley Act

The GLB Act authorizes BHCs and foreignbanks subject to the BHC Act to engage inmerchant banking activities if the banking orga-nization files with the Board a declaration that itelects to be an FHC and a certification that all ofits depository institution subsidiaries are wellcapitalized and well managed. To continue con-ducting merchant banking activities, each of thedepository institution subsidiaries of the BHC orforeign bank must continue to meet the well-capitalized and well-managed criteria. In addi-tion, at the time it commences any new mer-chant banking activity or acquires control of anycompany engaged in merchant banking activi-ties, a domestic bank subsidiary must have atleast a satisfactory rating under the CommunityReinvestment Act (CRA).

A BHC or foreign bank must provide noticeto the Board within 30 days after commencingmerchant banking activities or acquiring anycompany that makes merchant banking invest-ments. SR-00-1 (February 8, 2000) details theinformation required to be provided by BHCsand foreign banks electing FHC status and theprocedures for processing FHC elections.

Merchant banking investments may be con-ducted by a securities affiliate of the FHC or byan insurance company affiliate that providesinvestment advice to the insurance company andis registered under the Investment Advisers Actof 1940, or by an affiliate of such an adviser.Merchant banking investments may also bemade by other nonbank affiliates of FHCs, butmay not be acquired or held by a depositoryinstitution affiliate or subsidiary of a depositoryinstitution. A U.S. branch or agency of a foreignbank is considered a depository institution for

purposes of the rule and, therefore, may notacquire or hold merchant banking investments.

FHCs may make merchant banking invest-ments only as part of a bona fide underwriting,merchant banking, or investment bankingactivity—that is, for resale or other disposition.Investments may not be made for purposes ofengaging in the nonfinancial activities con-ducted by the entity in which the investment ismade.

Rules adopted by the Board and the Depart-ment of the Treasury, effective February 15,2001, impose the following limitations andrequirements on the conduct of merchant bank-ing activities.

Limitations on routine management. The GLBAct prohibits an FHC and its subsidiaries frombeing involved in the day-to-day ‘‘routine man-agement’’ of a portfolio company. Certainactivities, however, are deemed not to constituteroutine management. These activities include(1) having one or more representatives on theboard of directors of the portfolio company;(2) entering into covenants concerning actionsoutside of the ordinary course of business of theportfolio company; and (3) providing advisoryand underwriting services to, and consultingwith, a portfolio company. A December 21,2001, staff opinion describes examples of cov-enants that Board staff believe would generallybe permissible under the GLB Act and theimplementing regulations. (See www.federalreserve.gov/boarddocs/legalint.) These includecovenants that restrict the ability of the portfoliocompany to—

• alter its capital structure through the issuance,redemption, authorization, or sale of any equityor debt securities of the portfolio company;2

• establish the general purpose for funds soughtto be raised through the issuance or sale of anyequity or debt securities of the portfolio com-pany (for example, retirement of existing debt,acquisition of another company, or generalcorporate use);

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

• declare a dividend on any class of securities ofthe portfolio company or change the dividend-

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

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payment rate on any class of securities of theportfolio company;

• engage in a public offering of securities of theportfolio company;

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

• list (or de-list) any securities of the portfoliocompany on a securities exchange;

• create, incur, assume, guarantee, refinance, orprepay any indebtedness outside the ordinarycourse of business of the portfolio company;

• voluntarily file for bankruptcy, or consent tothe appointment of a receiver, liquidator,assignee, custodian, or trustee of the portfoliocompany for purposes of winding up its affairs;

• significantly alter the regulatory, tax, or liabil-ity status of the portfolio company (examplesof actions that would significantly alter theregulatory, tax, or liability status of the port-folio company include the registration of theportfolio company as an investment companyunder the Investment Company Act of 1940,or the conversion of the portfolio companyfrom a corporation to a partnership or limited-liability company);

• make, or commit to make, any capital expen-diture that is outside the ordinary course ofbusiness of the portfolio company, such as, thepurchase or lease of a significant manufactur-ing facility, an office building, an asset, oranother company;

• engage in, or commit to engage in, anypurchase, sale, lease, transfer, or other trans-action outside the ordinary course of businessof the portfolio company, which may includefor example—— entering into a contractual arrangement

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

— the sale of a significant asset of the port-folio company (for example, a significantpatent, manufacturing facility, or parcel ofreal estate);

— the establishment of a significant newsubsidiary by the portfolio company;

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

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

• hire, remove, or replace any or all of the

executive officers of the portfolio company;3

• establish, accept, or modify the terms of anemployment agreement with an executive offi-cer of the portfolio company, including theterms setting forth the executive officer’ssalary, compensation, and severance;

• adopt or significantly modify the portfoliocompany’s policies or budget concerning thesalary, compensation, or employment of theofficers or employees of the portfolio com-pany generally;

• adopt or significantly modify any benefit plancovering officers or employees of the portfoliocompany, including defined benefit and definedcontribution retirement plans, stock optionplans, profit sharing, employee stock owner-ship plans, or stock appreciation rights plans;

• alter significantly the business strategy oroperations of the portfolio company, for exam-ple, by entering or discontinuing a significantline of business or by altering significantly thetax, cash-management, dividend, or hedgingpolicies of the portfolio company; or

• establish, dissolve, or materially alter theduties of a committee of the board of directorsof the portfolio company.

Moreover, an FHC may routinely manage aportfolio company when it is necessary orrequired to obtain a reasonable return on theinvestment upon resale or disposition. The FHCmay only operate the portfolio company for theperiod of time necessary to address the specificcause prompting the FHC’s involvement, toobtain suitable alternative management arrange-ments, to dispose of the investment, or tootherwise obtain a reasonable return upon resaleor disposition of the investment. Written noticeto the Board is required for extended involve-ment, which is defined as over nine months. TheFHC must maintain and make available to theBoard upon request a written record describingits involvement in routinely managing the port-folio company.

Permissible holding periods. An FHC may,without any prior approval, own or control adirect merchant banking investment for up to 10years, and own or control an investment heldthrough a private equity fund for up to 15 years.If an FHC wants to hold an investment longer

3. The term ‘‘executive officer’’ is defined in section225.177(d) of Regulation Y.

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than the regulatory holding periods, a request forapproval must be submitted to the Board at least90 days before the expiration of the applicabletime period. When reviewing requests to holdinvestments in excess of the statutory timelimits, the Board will consider all of the factsrelated to the particular investment, including(1) the cost of disposing of the investmentwithin the applicable holding period, (2) thetotal exposure of the FHC to the portfoliocompany and the risks that disposing of theinvestment may pose to the FHC, (3) marketconditions, (4) the nature of the portfolio com-pany’s business, (5) the extent and history ofFHC involvement in the management andoperations of the portfolio company, and (6) theaverage holding period of the FHC’s merchantbanking investments. The FHC must deductfrom tier 1 capital an amount equal to 25 per-cent of the carrying value of the investment heldbeyond the regulatory holding period and abideby any additional restrictions that the Boardmay impose in connection with grantingapproval to hold the interest in excess of thetime limit.

An FHC must provide a written notice to theBoard within 30 days after acquiring more than5 percent of the voting shares, assets, or own-ership interests of any company under thissubpart, including interest in a private equityfund, at a total cost to the FHC that exceeds thelesser of 5 percent of the tier 1 capital of theFHC or $200 million. No post-acquisition noticeunder section 4(k)(6) of the BHC Act is requiredby an FHC in connection with a merchantbanking investment if the FHC has previouslyfiled a notice under section 225.87 of RegulationY indicating that it had commenced merchantbanking investment activities, except for thenotice of large individual investmentrequirements.

Equity investment policies and procedures. FHCsengaging in merchant banking activities musthave appropriate policies, procedures, and man-agement information systems. SR-00-9 identi-fies the structure of such policies and proceduresnot only for merchant banking activities but forall equity investments. The formality of thesepolicies and procedures should be commensu-rate with the scope, complexity, and nature ofthe institution’s equity investment activities andrisk profile. The required policies, discussed indepth in subsequent sections, should address thefollowing:

• types and amounts of merchant bankinginvestments

• parameters governing portfolio diversification• guidelines for holding periods and exit

strategies• hedging activities• investment valuation and accounting• investment-rating process• compensation and co-investment arrangements• periodic audits of compliance with established

limits and policies and applicable laws

In addition to limiting and monitoring exposureto portfolio companies that arises from tradi-tional banking transactions, banking organiza-tions should adopt policies and practices thatlimit the legal liability of the banking organiza-tion and its affiliates to the financial obligationsand liabilities of portfolio companies. Thesepolicies and practices may include the use oflimited-liability corporations or special-purposevehicles to hold certain types of investments, theinsertion of corporations that insulate liabilitybetween a bank holding company and a partner-ship controlled by the holding company, andcontractual limits on liability.

Sections 23A and 23B. Sections 23A and 23B ofthe Federal Reserve Act impose specific quan-titative, qualitative, and collateral requirementson certain types of transactions between aninsured depository institution and companiesthat are under common control with the insureddepository institution. The GLB Act includes apresumption that an FHC controls a companyfor purposes of sections 23A and 23B if it ownsor controls 15 percent or more of the equitycapital of the company. This ownership thresh-old is lower than the ordinary definition of anaffiliate, which is typically 25 percent. The finalrule identifies three ways that the GLB Actpresumption-of-control provision will be consid-ered rebutted:

• No officer, director, or employee of the FHCserves as a director, trustee, or general partner(or as an individual exercising similar func-tions) of the portfolio company.

• An independent third party owns or controlsmore than 50 percent of the voting shares ofthe portfolio company, and the officers andemployees of the FHC do not constitute amajority of the directors, trustees, or general

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partners (or individuals exercising similarfunctions) of the portfolio company.

• An independent third party owns or controls agreater percentage of the equity capital of theportfolio company than the FHC, and no morethan one officer or employee of the holdingcompany serves as a director, trustee, orgeneral partner (or as an individual exercisingsimilar functions) of the portfolio company.

If the FHC investment meets any of theseconditions and there are no other circumstancesthat indicate that the FHC controls the portfoliocompany, the presumption of control will bedeemed rebutted. However, if the FHC’s invest-ment does not meet one of these criteria, theholding company may still request a determina-tion from the Board that it does not control thecompany.

Cross-marketing limitations. A depository insti-tution controlled by an FHC may not cross-market the products or services of a portfoliocompany if more than 5 percent of the compa-ny’s voting shares, assets, or ownership interestsare owned or controlled by the FHC under themerchant banking authority. A portfolio com-pany that meets the foregoing ownership crite-rion may not cross-market the products or ser-vices of the depository institution subsidiaries ofthe FHC. Management should ensure that theselimits are observed through internal controls tomonitor transactions with portfolio companiesthat are deemed affiliates.

Regulatory Capital Requirements

In January 2002, the Board, Office of the Comp-troller of the Currency, and Federal DepositInsurance Corporation (the agencies) jointly pub-lished a rule establishing special minimum regu-latory capital requirements for equity invest-ments in nonfinancial companies. The newcapital requirements, which apply symmetri-cally to banks and bank holding companies,impose a series of marginal capital charges oncovered equity investments that increase withthe level of a banking organization’s overallexposure to equity investments relative to tier 1capital. The capital rules apply to equity invest-ments made under—

• the merchant banking authority of section4(k)(4)(H) of the BHC Act (12 USC

1843(k)(4)(H)) and subpart J of the Board’sRegulation Y;

• the authority to acquire up to 5 percent of thevoting shares of any company under section4(c)(6) or 4(c)(7) of the BHC Act (12 USC1843(c)(6) and (c)(7));

• the authority to invest in SBICs under section302(b) of the Small Business Investment Actof 1958 (15 USC 682(b));

• the portfolio investment provisions of Regu-lation K (12 CFR 211.8(c)(3)), including theauthority to make portfolio investments throughEdge and agreement corporations; and

• the authority to make investments under sec-tion 24 of the FDI Act (other than undersection 24(f)) (12 USC 1831a).

An equity investment includes the purchase,acquisition, or retention of any equity instru-ment (including common stock, preferred stock,partnership interests, interests in limited-liabilitycompanies, trust certificates, and warrants andcall options that give the holder the right topurchase an equity instrument), any equity fea-ture of a debt instrument (such as a warrant orcall option), and any debt instrument that isconvertible into equity. The rule generally doesnot apply to investments in nonconvertible senioror subordinated debt. The agencies, however,may impose the rule’s higher charges on anyinstrument if an agency, based on a case-by-casereview of the instrument in the supervisoryprocess, determines that the instrument serves asthe functional equivalent of equity or exposesthe banking organization to essentially the samerisks as an equity investment.

The capital charge applies to investments helddirectly or indirectly in ‘‘nonfinancial compa-nies’’ under one of the authorities listed above.A nonfinancial company is defined as an entitythat engages in any activity that has not beendetermined to be financial in nature or incidentalto financial activities under section 4(k) of theBHC Act. For investments held directly orindirectly by a bank, the term ‘‘nonfinancialcompany’’ does not include a company thatengages only in activities that are permissiblefor the parent bank to conduct directly.

The rule does not impose an additional regu-latory capital charge on SBIC investments helddirectly or indirectly by a bank to the extent thatthe aggregate adjusted carrying value of all suchinvestments does not exceed 15 percent of thetier 1 capital of the bank. For BHCs, no addi-tional regulatory capital charge is imposed on

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SBIC investments held directly or indirectly bythe holding company to the extent the aggregateadjusted carrying value of all such investmentsdoes not exceed 15 percent of the aggregate ofthe holding company’s pro rata interests in thetier 1 capital of its subsidiary banks. However,the adjusted carrying value of such investmentsmust be included in determining the total amountof nonfinancial equity investments held by thebanking organization in relation to its tier 1capital, and thus the marginal capital charge thatapplies to the organization’s covered equityinvestments. Investments made by a state bankunder the authority in section 24(f) of the FDIAct are also exempt from additional regulatorycapital charges. The rule does not apply thehigher capital charges to equity securitiesacquired and held by a bank or BHC as a bonafide hedge of an equity derivatives transactionlawfully entered into by the institution.

The rule does not apply to investments madein community development corporations under12 USC 24 (eleventh), or to equity securitiesthat are acquired in satisfaction of a debt previ-ously contracted (DPC) and that are held anddivested in accordance with applicable law. Therule also does not apply to equity investmentsmade under section 4(k)(4)(I) of the BHCA byan insurance underwriting affiliate of an FHC.

A grandfather provision exempts from thehigher capital charges any individual investmentmade by a bank or BHC before March 13, 2000,or made after such date pursuant to a bindingwritten commitment entered into before March13, 2000. An investment qualifies for grand-father rights only if the banking organization hascontinuously held the investment since March13, 2000. For example, if the banking organiza-tion sold 40 shares of a grandfathered invest-ment in Company X on March 15, 2000, andpurchased another 40 shares of Company X onDecember 31, 2000, the 40 shares would beineligible for grandfathered status. Shares orother interests received by a banking organiza-tion through a stock split or stock dividend on agrandfathered investment are not considerednew investments if the banking organizationdoes not provide any consideration for theshares or interests and the transaction does notmaterially increase the organization’s propor-tional interest in the portfolio company. Theadjusted carrying value of grandfathered invest-ments must be included in determining the totalamount of nonfinancial equity investments heldby the banking organization in relation to its tier

1 capital, and thus the marginal capital chargethat applies to the organization’s covered equityinvestments.

The marginal capital charges are applied bymaking a deduction from the banking organiza-tion’s tier 1 capital. For investments with anaggregate adjusted carrying value equal to lessthan 15 percent of the banking organization’stier 1 capital, 8 percent of the aggregate adjustedcarrying value is deducted from tier 1 capital.For investments with an aggregate adjustedcarrying value equal to 15 to 24.99 percent ofthe banking organization’s tier 1 capital, 12 per-cent of the aggregate adjusted carrying value isdeducted from tier 1 capital. For investmentswith an aggregate adjusted carrying value inexcess of 25 percent of the banking organiza-tion’s tier 1 capital, 25 percent of the aggregateadjusted carrying value is deducted from tier 1capital.

The adjusted carrying value of an investmentis the value at which the investment is recordedon the balance sheet of the banking organiza-tion, reduced by (1) net unrealized gains that areincluded in carrying value but have not beenincluded in tier 1 capital and (2) associateddeferred tax liabilities. The total adjusted carry-ing value of a banking organization’s nonfinan-cial equity investments that is subject to adeduction from tier 1 capital will be excludedfrom the organization’s average total consoli-dated assets for purposes of computing thedenominator of the organization’s tier 1 lever-age ratio.

The capital requirements established by therule are minimum levels of capital required toadequately support a banking organization’sequity investment activities. The rule requiresbanking organizations to maintain, at all times,capital that is commensurate with the level andnature of the risks to which they are exposed,including the risks of private equity and mer-chant banking investments. The Board mayimpose a higher capital charge on the nonfinan-cial equity investments of a banking organiza-tion if the facts and circumstances indicate thata higher capital level is appropriate in light ofthe risks associated with the organization’sinvestment activities.

Internal Capital

Consistent with the guidelines identified in SR-99-18 (July 1, 1999), institutions conducting

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material equity investment activities are expectedto have internal methods for allocating capitalbased on the inherent risk and control environ-ment of these activities. These methodologiesshould identify material risks and their potentialimpact on the safety and soundness of theconsolidated entity. Internal capital-allocationmethodologies for equity-investing activitiesconsider both the risks posed by the broadermarket and those risks specific to the underlyingportfolio companies. Other relevant risks mayinclude country, business, and operational risk.More sophisticated banking organizations alsoidentify the risks inherent in and allocate capitalto equity-investing activities based on the invest-ment stage (early-stage seed investments tolater-stage buyouts) and type of investment(public versus private).

The level of capital dedicated to equity-investing activities should be appropriate to thesize, complexity, and financial condition of thebanking organization. Accordingly, it is gener-ally appropriate for banking organizations tomaintain capital in excess of minimum regula-tory requirements to ensure that equity invest-ment activities do not compromise the integrityof the institution’s capital. Examiners should notonly assess the institution’s compliance withregulatory capital requirements and the qualityof regulatory capital, but also review an institu-tion’s methodologies for internally allocatingcapital to this business line. As set forth inSR-99-18, the fundamental elements of a soundinternal analysis of capital adequacy include(1) identifying and measuring all material risks,(2) relating capital to the level of risk, (3) statingexplicit capital adequacy goals with respect torisk, and (4) assessing conformity to the institu-tion’s stated objectives. For equity-investingactivities in particular, changes in the risk profileof the banking organization’s equity portfolio,including the introduction of new instruments,increased investment volumes, changes in port-folio composition or concentrations, changes inthe quality of the bank’s portfolio, or changes inthe overall economic environment, should bereflected in risk measurements and internal capi-tal levels.

Risk-measurement methodologies for publicsecurities generally reflect price declines basedon standard stress scenarios. The selected stress-test benchmark should be appropriate to thecharacteristics of the portfolio holdings (forexample, the sensitivity of small company–oriented portfolios may be more closely corre-

lated to a Russell index rather than the S&P500). A common approach to estimating industry-specific declines reflects the application of indus-try beta adjustments to each portfolio company.

Techniques can also be employed to measurethe estimated exposure of the portfolio to unfa-vorable price moves over an extended holdingperiod. The analysis is based on the historicalvolatility of each investment at a selected con-fidence interval. The process is based on thelongest period for which historical volatilitydata are available.

Internal capital-allocation methodologies forprivate equity investments should consider boththe market and credit risks inherent in this assetclass. However, most methodologies employedto determine capital allocation for the marketrisk inherent in private equity investments aretypically volatility-based approaches. Stress-testscenarios reflect conditions that prevailed duringhistorically volatile equity markets with theresults adjusted by industry betas. A number ofbanking organizations employ industry-adjusted,historical volatility–based measures to estimatethe risk to private equity valuations from declinesin earnings multiples. Some banking organiza-tions base their stress scenarios on historical-volatility data provided by private equity ven-dors. While exposure to broader market risk isconsidered nondiversifiable, measurement ofcredit-specific risk should attempt to identifyrisk at the portfolio company–specific level, aswell as identify other idiosyncratic factors thatcould result in impairments of value.

The amount of capital held should not onlyreflect measured levels of risk, but also considerpotential uncertainties in risk measurement. Abanking organization’s internal capital shouldreflect an adequate cushion to take into accountthe perceived level of precision in the riskmeasures used, the potential volatility of expo-sures, and the relative importance to the institu-tion of equity-investing activities.

Banking organizations should be able to dem-onstrate that their approach to relating capital torisk is conceptually sound and that results arereasonable. In assessing its approach, an insti-tution may use sensitivity analysis of key inputsand compare its practices to peer practices.

Other Laws and Regulations

The conduct of equity investment activities issubject to different laws and regulations, depend-

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ing on the authority under which the activitiesare conducted. Compliance with all laws andregulations applicable to the institution’s invest-ment activities should be a focus of the institu-tion’s system of internal controls. Regulatorycompliance requirements should be incorpo-rated into internal controls so that managersoutside of the compliance or legal functionsunderstand the parameters of permissible invest-ment activities.

In particular, examiners should determinewhether the institution has an effective programfor compliance with federal and state securitieslaws and regulations. This is particularly impor-tant if the institution offers private equity fundinvestments to its private-banking customers.These investments generally represent a long-term and illiquid investment. Significant returnson investment may not be realized until the laterstages of the funds’ terms. Therefore, fundinvestments generally are suitable only forinvestors that can bear the risk of holding theirinvestments for an indefinite time period and therisk of investment loss. Examiners should ensurethat management has established a process toreview to whom the funds are marketed and howthe banking organization verifies that a custom-er’s investment in the fund is suitable. As ageneral matter, fund investments are deemed tobe suitable investments only after it is deter-mined that—

• the client’s investment in the fund is compat-ible with the size, condition, and nature of theclient’s investment objective, and

• the client has the capability (either personallyor through independent professional advice)to understand the nature, material terms, con-ditions, and risks of the fund.

Examiners should encourage staff involved inmarketing funds to private-banking clients touse an investor-suitability checklist. In addition,the Investment Company Act of 1940 and theSecurities Act of 1933, as well as state securitieslaws, may impose restrictions on the sale of fundinterests. Banking organizations involved in fundsales should consult with qualified securitiescounsel.

RISK MANAGEMENT

A banking organization engaged in equity invest-ment activities must maintain policies, proce-

dures, records, and systems reasonably designedto conduct, monitor, and manage such invest-ment activities, as well as the risks associatedwith them, in a safe and sound manner. Thebanking organization should have a sound pro-cess for executing all elements of investmentmanagement, including initial due diligence,periodic reviews of holdings, investment valua-tion, and realization of returns. This processrequires appropriate policies, procedures, andmanagement information systems, the formalityof which should be commensurate with thescope, complexity, and nature of an institution’sequity investment activities. A sound invest-ment process should be applied to all equityinvestment activities, regardless of the legalentity in which investments are booked. Super-visory reviews of equity investment activitiesshould be risk-focused, taking into account theinstitution’s stated tolerance for risk, the abilityof senior management to govern these activitieseffectively, the materiality of activities in lightof the institution’s risk profile, and the capitalposition of the institution.

Policies, procedures, records, and systemsshould be reasonably designed to—

• delineate the types and amounts of invest-ments that may be made;

• provide guidelines on appropriate holdingperiods for different types of investments;

• establish parameters for portfoliodiversification;

• monitor and assess the carrying value, marketvalue, and performance of each investmentand the aggregate portfolio;

• identify and manage the market, credit, con-centration, and other risks;

• identify, monitor, and assess the terms, amounts,and risks arising from transactions and rela-tionships (including contingent fees or inter-ests) with each company in which the FHCholds an interest;

• ensure the maintenance of corporate separate-ness between the FHC and each company inwhich the FHC holds an interest under mer-chant banking authority, and protect the FHCand its depository institution subsidiaries fromlegal liability for the operations conducted andfinancial obligations of each such company;and

• ensure compliance with laws and regulationsgoverning transactions and relationships withcompanies in which the FHC holds an interest.

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Portfolio-diversification policies should identifyfactors pertinent to the risk profile of the invest-ments being made, such as industry, sector,geographic, and market factors. Policies estab-lishing expected holding periods should specifythe general criteria for liquidation of invest-ments and guidelines for the divestiture of anunderperforming investment. Decisions to liqui-date underperforming investments are necessar-ily made on a case-by-case basis considering allrelevant factors; however, policies and proce-dures stipulating more frequent review andanalysis are generally used to address invest-ments that are performing poorly or have beenin portfolio for a considerable length of time.Policies should identify the aggregate exposurethat the institution is willing to accept, by typeand nature of investment. Adherence to theseexposure limits should take into considerationunfunded, as well as funded, commitments.

Many institutions have different proceduresfor assessing, approving, and reviewing invest-ments based on the size, nature, and risk profileof an investment. Often, procedures used fordirect investments are different from those usedfor indirect investments made through privateequity funds. For example, different levels ofdue diligence and senior-management approvalsmay be required. Accordingly, managementshould ensure that the infrastructure for conduct-ing these activities contains operating proce-dures and internal controls that appropriatelyreflect the diversity of investments. Supervisorsshould recognize this potential diversity of prac-tice when conducting reviews of the equityinvestment process. Their focus should be on(1) the appropriateness of the process employedrelative to the risk of the investments made,(2) the materiality of the equity investmentbusiness line to the overall soundness of thebanking organization, and (3) the potentialimpact on affiliated depository institutions.

Well-founded analytical assessments of invest-ment opportunities and formal processes forapproving investments are critical in conductingequity investment activities. While analyses andapproval processes may differ by individualinvestments and across institutions, the methodsand types of analyses conducted should beappropriately structured to assess adequately 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 through

formal investment decision, should be docu-mented and clearly understood by the staffconducting these activities.

An institution’s evaluation of potential invest-ments in private equity funds, as well as reviewsof existing fund investments, should involveassessments of a fund’s structure, with dueconsideration given to (1) management fees,(2) carried interest and its computation on anaggregate portfolio basis, (3) the sufficiency ofgeneral partners’ capital commitments in pro-viding management incentives, (4) contingentliabilities of the general partner, (5) distributionpolicies and wind-down provisions, and (6) per-formance-based return-calculation methodolo-gies. A banking organization must make itspolicies, procedures, and records available to theBoard or the appropriate Reserve Bank uponrequest. A banking organization must providereports to the appropriate Reserve Bank in suchformat and at such times as the Board mayprescribe.

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 elements of theinvestment-management process, focusing onthe appropriateness of existing policies andprocedures; adherence to policies and proce-dures; and the integrity and adequacy of invest-ment valuations, risk identification, regulatorycompliance, and management reporting. Seniormanagement should review and documentdepartures from policies and procedures, andthis documentation should be available forexaminer review.

As with other financial activities, assessmentsof compliance with both written and impliedpolicies and procedures should be independentof line decision-making functions to the fullestextent possible. Large complex banking organi-zations with material equity investment activi-ties should have periodic independent reviewsof their investment process and valuation meth-odologies by internal auditors or independentoutside parties. In smaller, less complex institu-tions where limited resources may precludeindependent review, alternative checks and bal-

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ances should be established, such as randominternal audits, senior management reviews ofthe function, or the use of outside third parties.

Management Information Systems andReporting Mechanisms

The board of directors and senior managementshould ensure that the risks associated withprivate equity investments and merchant bank-ing activities do not adversely affect the safetyand soundness of the banking organization andits affiliated insured depository institutions. Anadequate and detailed management informationsystem (MIS) is essential for managing equityinvestments and allowing the board of directorsto actively monitor the performance and riskprofile of equity investment business lines inlight of established objectives, strategies, andpolicies.

MIS should be commensurate with the scope,complexity, and nature of an institution’s equityinvestment activities. The following MIS reportsmay be appropriate for a banking organizationengaged in equity investment activities. Examplesof annual reports include the—

• strategic plan, which should detail countryand industry limits and concentrations, earn-ings goals based on IRRs, and investmentplans;

• budget, which should show performanceresults versus projections and identify antici-pated investments for the next annual period;and

• annual peformance review, which shouldclearly identify sources of revenue (such asunrealized gains or losses, dividend income,or realized gains or losses).

Examples of monthly and quarterly reports are—

• portfolio-valuation reports that provide, foreach material investment, a brief overview ofthe investment, the unrealized gain or loss,any unfunded commitments or contingencies,and projected exit timetables;

• portfolio-wide performance and statistical data,including gains or losses on the portfolio forthe period and the performance of any hedg-ing strategies;

• the results of any stress tests;• analyses of concentrations by sector, industry,

geographic location, or type of investment;• regulatory compliance reports;• management and investment committee reports

that make commitments for or approve newtransactions or a redirection of corporate plans;and

• a semiannual investment-portfolio review,which is a full review of the equity investmentportfolio that determines the quality (valua-tion) of the assets by reviewing and analyzingtheir financial condition, management assess-ment, future prospects, strengths and weak-nesses, and exit strategies.

In addition to a review of the content of MISreports, examiners should determine whetherreports are prepared and disseminated to seniormanagement and the board (or an appropriatecommittee of the board) on a timely basis.Reports provided to senior management and theboard should be readily understandable by mem-bers who are not experts in the equity invest-ment business line.

The sophistication of the software a bankingorganization employes to conduct equity-investing activities will depend on the complex-ity of those activities. Several software optionsare available to simplify portfolio management,monitoring, and reporting.

A quality portfolio database should be easy touse and logical, have general-ledger capabilities,access information readily, be network-readyand compatible with the operating system, anduse a programming language based on industry-established sound practices. In general, a com-prehensive software system should be able toproduce the following reports:

• risk summary data for the investment port-folio, for example, by industry, investmentstage, and geographic region;

• comprehensive data for each investment hold-ing (its cost, market, IRR, net cash flows, andlegal entity and authority); and

• the unfunded commitments schedule and stockdistributions.

In addition, if the banking organization sponsorsa fund of funds, additional features of a com-prehensive software system could include theability to provide information on—

• total commitments;• individual-investor contributions;• distributions to individual investors;

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• IRRs and total returns by individual fund,vintage year, and portfolio; and

• exposures by stage, industry, geographicregion, and company.

Hedging Activities

A limited number of banking organizations haveengaged in hedging strategies in an effort toreduce the impact of volatility on their holdings.The expansion of international private equityinvestments in the increasingly global financial-products market has given rise to foreign-exchange risk exposure, as well as market-riskexposure. Hedging strategies have been devel-oped to reduce these risks at some large com-plex banking organizations (LCBOs) that havematerial foreign equity investments.

The most basic hedging strategy is to capturea portion of an investment’s unrealized increasein fair value through the purchase of a long putoption. The cost of this strategy is the premiumprice of the option, which varies with the strikeprice and maturity. The closer the underlyinginstrument’s market value is to the strike price,the more expensive the premium and vice versa.

To avoid the premium cost of the long put, theequity investor may instead purchase a ‘‘cost-less’’ collar, in which the premium paid for theput is offset by the premium received on the saleof the call. The collar limits both the upsidepotential and downside risk of the investmentthrough the purchase of a put and the sale of acall. A collar strategy can be an effective hedg-ing strategy if the value of the investment isexpected to remain relatively stable or decline.However, if the value of the investment increases,the holder of the call option is likely to exercise,and the banking organization (the seller) willforgo the appreciation in the value of the invest-ment.

Another transaction used to hedge equityexposure is an equity swap. A specific price isestablished for the investment, and cash flowsare paid to the purchaser or seller of the swap,depending on whether the underlying securityvalue increases or decreases.

Most of the hedging instruments describedabove, particularly the option strategies, areEuropean in nature, meaning that the option orembedded option may only be exercised on thestated maturity date. This feature may poseliquidity issues for the banking organization if itdesires to sell its directly held investment or if

the general partner of a fund investment thatholds marketable securities decides to liquidatea hedged investment before option maturity. Insuch cases, the banking company is effectivelyshort the underlying investment until the matu-rity date. To maintain their business relation-ships, counterparties offering the hedging prod-ucts will allow banking organizations to unwindcontracts for a fee when an unanticipated saleoccurs. In selected cases, the banking organiza-tion may be required to post collateral to thecounterparty for the hedging transaction. Mostbanking organization equity-investing units donot hold U.S. Treasury obligations in portfolio;therefore, the most common form of collateralprovided is cash. In certain cases, the parentcompany will provide a guarantee on behalf ofthe equity-investing unit if it is a standalonesubsidiary engaged in these activities. Commoncurrency-hedging strategies for investmentsmade in the international markets are currencyforward sales or, to a lesser extent, optiontransactions.

If a banking organization uses hedging strat-egies to conduct equity investment activities,examiners should assess whether the organiza-tion has in place—

• formal and clearly articulated hedging policiesand strategies, approved by the board ofdirectors or an appropriate committee, thatidentify limits on hedged exposures and per-missible hedging instruments;

• procedures for the review of hedging transac-tions for compliance with Statement of Finan-cial Accouting Standards No. 133 (FAS 133),as amended by Statement of Financial Account-ing Standards Nos. 137 and 138 (FAS 137 andFAS 138); and

• appropriate management information systemsand reporting systems for monitoring the hedgestrategies. Systems should include mark-to-market valuation of the hedging instruments,premium amortization of purchased instru-ments, and an all-in performance evaluationthat includes the current fair value of theunderlying position.

COMPENSATIONARRANGEMENTS

The need to maintain a qualified staff is anextremely important aspect of risk managementin equity investing. In many instances, the

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compensation package for professional equityinvestment staff includes a co-investmentarrangement under which the professional staffinvests on a percentage basis in each of theportfolio companies or funds in which the bank-ing organization invests during the year. Gener-ally, a new co-investment partnership is formedannually so that each partnership reflects invest-ments made in a particular calendar year. Theduration of the partnership corresponds to theexpected holding period of the investments inthe partnership.

Each professional staff member’s percentageof ownership within the partnership generally isbased on that individual’s tenure, experience, orrank. Staff members generally contribute a por-tion of the partnership’s investment in cash; theremaining portion of the investment may beborrowed from the parent bank holding com-pany or a nonbank subsidiary at a market rate,such as the applicable federal rate (AFR), whichis published monthly by the IRS. While theholding company or a nonbank subsidiary mayprovide loans to the investing employees, it isrecommended that the employees be required tofurnish a portion of the investment with fundsthat have not been borrowed.

The borrowings should be serviced accordingto formal written agreements, and full paymentof amounts borrowed, with interest, should bemade before any partnership distributions to theemployees. A private equity subsidiary shouldestablish clear policies and procedures govern-ing compensation arrangements, includingco-investment structures, terms and conditionsof employee loans, and sales of participants’interests, before the release of any liens.

If a partnership does not participate in everyinvestment of the venture subsidiary, the exam-iner should consider this practice, known as‘‘ cherry picking,’’ to be an exception worthy ofcriticism, as the intent of co-investment arrange-ment is for senior management responsible forthe business line to share the investment riskswith the banking organization. Moreover, if theinvestments in the portfolio are hedged, theinvestments in the co-investment plan shouldalso be hedged, regardless of whether the hedgeis in place to protect the upside profit potentialor to minimize the downside risk. The importantpoint is that co-investment plans consistentlyshare in both the upside potential and downsiderisks of investment activities.

Other equity investment compensation plansbase remuneration in whole or in part on the

performance of the equity investment portfolios.This method is less accepted within the industry.If compensation is based on investment perfor-mance, a thorough understanding of the formulaused and the underlying accounting treatmentsmust be determined. Unrealized gains generallyshould not be included in determining compen-sation, as they do not reflect funds taken intoincome by the banking organization and maynot ultimately be realized.

NONINVESTMENT BUSINESSTRANSACTIONS

Additional risk-management issues arise when abanking institution or an affiliate lends to or hasother business relationships with (1) a companyin which the banking institution or an affiliatehas invested (that is, a portfolio company),(2) the general partner or manager of a privateequity fund that has also invested in a portfoliocompany, or (3) a private-equity-financed com-pany in which the banking institution does nothold a direct or indirect ownership interest butthat is an investment or portfolio company of ageneral partner or fund manager with which thebanking organization has other investments.Given their potentially higher than normal riskattributes, institutions should devote special at-tention to ensuring that the terms and conditionsof such lending relationships are at arm’s length,in accordance with section 23B of the FederalReserve Act, and are consistent with the lendingpolicies and procedures of the institution. Simi-lar issues may arise in the context of derivativetransactions with or guaranteed by portfoliocompanies and general partners.

Lending and other business transactionsbetween an insured depository institution and aportfolio company that meets the definition ofan affiliate must comply with sections 23A and23B of the Federal Reserve Act. The holdingcompany should have systems and policies inplace to monitor transactions between the hold-ing company, or a nondepository institutionsubsidiary of the holding company, and a port-folio company, as these transactions are nottypically governed by section 23B. A holdingcompany should ensure that the risks of thesetransactions, including exposures of the holdingcompany on a consolidated basis to a singleportfolio company, are reasonably limited andthat all transactions are on reasonable terms,

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with special attention paid to transactions thatare not on market terms.

When a banking organization lends to aprivate-equity-financed company in which it hasno equity interest but in which the borrowingcompany is a portfolio investment of privateequity fund managers or general partners withwhich the institution may have other privateequity–related relationships, care must be takento ensure that the extension of credit is grantedon reasonable terms. In some cases, lenders maywrongly assume that the general partners oranother third party implicitly guarantees or standsbehind such credits. Reliance on implicit guar-antees or comfort letters should not substitutefor reliance on a sound borrower that is expectedto service its debt with its own resources. Aswith any type of credit extension, absent awritten contractual guarantee, the credit qualityof a private equity fund manager, general part-ner, or other third party should not be used toprevent the classification or special mention of aloan. Any tendency to relax this restriction whenthe general partners or sponsors of private-equity-financed companies have significant busi-ness dealings with the banking organizationshould be strictly avoided. Banking organiza-tions that extend credit to companies in whichthe institution has made an equity investmentshould also be aware of the potential for equi-table subordination of the lending arrangements.

DISCLOSURE OF EQUITYINVESTMENT ACTIVITIES

Given the important role that market disciplineplays in controlling risk, institutions should

ensure that they adequately disclose the infor-mation necessary for markets to assess an insti-tution’s risk profiles and performance in theequity investment business line. Indeed, it is inthe interests of the institution itself, as well as 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. Supervisors should use such disclosures,as well as periodic regulatory reports filed bypublicly held banking organizations, as part ofthe information that they review routinely. Thefollowing topics are relevant for public disclo-sure, though disclosures regarding each of thesetopics may not be appropriate, relevant, orsufficient in every case:

• the size of the portfolio• the types and nature of investments (for exam-

ple, direct/indirect, domestic/international,public/private, equity/debt with conversionrights)

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

• accounting techniques and valuation method-ologies, including key assumptions and prac-tices affecting valuation and changes in thosepractices

• realized gains or losses arising from sales andunrealized gains or losses

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

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Equity Investment and Merchant Banking ActivitiesExamination Objectives Section 3040.2

Reviews of the equity investment and merchantbanking activities should be risk-focused andrely on any findings of the primary or functionalsupervisors, where available and applicable. Inselecting investments for review, a cross-sectionof investments should be targeted. The selectionprocess should extend across specific sectors inwhich the banking organization has materialinvestments. A mix of both recent and seasonedinvestments should be selected to determinewhether changes have occurred in the underwrit-ing, accounting, or valuation processes or ininvestment performance. When preparing toreview equity-investing activities, the reviewteam should collect any available backgroundinformation from prior reviews, risk assess-ments, regulatory reports, or publicly availableinformation.

1. Identify the extent to which the bankingorganization is engaged in equity invest-ment and merchant banking activities, thetypes of investments made, and activitiesconducted, and determine the materiality ofthese activities to the institution’s earningsand capital.

2. Identify and, to the extent possible, quantifythe material risks posed by the bankingorganization’s equity investment and mer-chant banking activities.

3. Determine whether the board of directorsand senior management understand the riskprofile of the banking organization’s equity-investing activities.

4. Determine whether the accounting and valu-ation policies and practices for the equityinvestment business line are appropriate,clearly articulated, consistently applied inaccordance with generally accepted account-ing principles (GAAP), and properlydisclosed.

5. Determine whether write-downs or adjust-ments to the valuation of investments aremade in appropriate amounts and in a timelymanner.

6. Evaluate the quality and timeliness ofportfolio-valuation reviews.

7. Evaluate the adequacy and effectiveness ofthe policies, procedures, and processesdesigned to ensure compliance with appli-cable laws, regulations, and supervisory

guidance governing equity investment andmerchant banking activities.

8. Determine the adequacy of the institution’sregulatory and internally allocated capitalrelative to the activities conducted and theinherent risks.

9. Evaluate the institution’s framework of poli-cies, procedures, systems, and internal con-trols designed to measure, monitor, andcontrol investment risks.

10. Determine whether the banking organiza-tion’s management information systems(MIS) and reporting mechanisms are com-mensurate with the scope, complexity, andnature of its equity investment and mer-chant banking activities.

11. Determine the adequacy of internal andexternal risk-management and audit reviews.

12. Determine the adequacy of policies andprocedures governing any hedging activi-ties authorized in connection with the bank-ing organization’s equity investment andmerchant banking activities, and determinewhether any of these activities are con-ducted in accordance with Statement ofFinancial Accounting Standards No. 133(FAS 133), as amended by Statement ofFinancial Accounting Standards Nos. 137and 138 (FAS 137 and FAS 138).

13. Determine that personnel working in equity-investing activities are technically compe-tent and well trained; ethical standards areestablished, communicated, and respected;and compensation arrangements are clearlydocumented and appropriate.

14. Assess any lending-based or noninvestmentbusiness relationships with portfolio com-panies, portfolio company managers, or gen-eral partners of equity investment venturesand funds, and determine whether suchtransactions are being conducted in accor-dance with applicable laws and supervisoryguidance and in a manner that does notcompromise the safety or soundness ofinsured depository institution subsidiaries.

15. Determine the adequacy of internal andpublic disclosures of equity investmentactivities, and recommend improvementswhen warranted.

16. Recommend corrective action when poli-cies, procedures, practices, internal con-trols, or management information systems

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are found to be deficient or when violationsof laws, rulings, or regulations have beennoted.

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Equity Investment and Merchant Banking ActivitiesExamination Procedures Section 3040.3

TYPES OF EQUITYINVESTMENTS

1. Assess the composition of investments amongdirect investments, indirect investmentsthrough limited partnership funds, and indi-rect investments through funds of funds.Identify the types of equity instruments thebanking organization holds (for example,common and preferred stock, convertibledebt, warrants, and partnership interests) andthe stage of development of portfolio com-panies (for example, start-up, growth, buy-out, and recapitalization). Identify any issueror industry-sector concentrations.

2. Determine if activities are managed alonglegal-entity or functional-business-unit lines.Identify the number of geographic officesthrough which investment activities are con-ducted, including any non-U.S. sites. Whereapplicable, determine how foreign organiza-tions book and manage investments (that is,whether investments are booked in offshorevehicles rather than in U.S.-domiciled entities).

3. Determine whether and to what extent thebanking organization serves as the generalpartner of private equity funds, and reviewany partnership agreements, fund-offeringdocuments, or other pertinent information.Determine whether private equity funds areoffered to the banking organization’s private-banking clients, and, if so, review relevantdocumentation.

ACCOUNTING AND VALUATION

1. Evaluate the appropriateness of the bankingorganization’s accounting treatment of vari-ous types of equity investments.

2. Determine whether the banking organizationhas established a valuation policy that estab-lishes appropriate methodologies for eachtype of equity investment held (for example,private direct, funds, public security invest-ments) or stage of investment. Determine ifthe valuation policy is applied consistentlyover time.

3. Assess the banking organization’s currentyear-to-date write-offs, write-downs, write-ups, and recoveries in light of past trends andcurrent market conditions.

4. Determine the appropriateness of the factorsthe banking organization considered in deter-mining whether to make private-security valu-ation adjustments, and assess whether thebanking organization’s policies clearly articu-late conditions and criteria for indicatingother-than-temporary impairment of privateequity investments.

5. If the banking organization discounts publicsecurities, determine whether policies estab-lish a rigid matrix of discounts or provide fora more subjective approach. If a subjectiveapproach is used, determine how it is appliedand documented.

6. Determine how the banking organization val-ues fund investments. Are fund-investmentvaluation adjustments based on quarterlygeneral-partner statements, or does the bank-ing organization monitor the potential impacton its fund valuations based on an analysis ofthe underlying portfolio companies?

7. Determine whether acceptable levels of docu-mentation support valuation decisions. Deter-mine whether reviews of valuation method-ologies are supported by robust documentation(especially where valuations reflect consider-ation of subjective factors).

8. Assess whether valuation reviews are com-prehensive and timely, given the nature andcomplexity of the banking organization’sinvestment activities.

9. Identify the level of unfunded commitmentsand the banking organization’s ability tomeet those commitments.

COMPLIANCE WITH LAWS ANDREGULATIONS

1. Identify and verify the various legal authori-ties through which the banking organizationengages in equity-investing activities. If appli-cable, has the BHC (or foreign bank) prop-erly notified the appropriate Reserve Bankthat it has elected to become a financialholding company (FHC) and that it hasinitiated merchant banking investmentactivities?

2. Verify that the firm’s FR Y-12 accuratelyreflects the activities as conducted.

3. Identify and assess the regulatory-complianceprocess for the equity investment business

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line, and assess how the process is coordi-nated with the consolidated compliancefunction.

4. Verify that board and senior managementoversight of investing activities is commen-surate with the complexity of the portfolio(or portfolios). Are reports provided on atimely basis, and do reports reflect the com-plexity and risk profile of the institution’sactivities?

5. Determine if the banking organization hasestablished written policies and proceduresfor monitoring compliance with the applica-ble laws, regulations, and supervisory guid-ance, including but not limited to the rules insubpart J of Regulation Y (governing mer-chant banking activities), sections 23A and23B of the Federal Reserve Act, and SR-00-9.

6. Determine the process for monitoring com-pliance with sections 23A and 23B of theFederal Reserve Act. Identify what system orprocess has been established at the holdingcompany to monitor transactions between(1) any portfolio companies or fund manag-ers that are considered affiliates and (2) itsaffiliate banks.

7. Request and review documentation on thebanking organization’s capital-allocation over-sight infrastructure, and review how the pro-cess incorporates all consolidated nontradingequity holdings. Determine if managementhas effectively related the level of capitalallocated for equity-investing activities to thelevel of inherent portfolio risks. Do internalcapital allocations distinguish between differ-ent types of equity-related investments,including public, private, limited partnershipfunds, and mezzanine holdings? Are unfundedcommitments to limited partnership fundsincluded?

8. For those banking organizations employingvalue-at-risk (VaR) and volatility techniquesto estimate portfolio risk for internal capital-allocation purposes, assess the following:a. What is the simulation time horizon (quar-

terly or annual)?b. How appropriate is the historical data

sample to be used (source and length oftime)?

c. How does the banking organization mapits investments to industry-specific marketindices to determine volatilities and cross-industry correlations?

d. How frequently are positions and volatili-ties reviewed?

e. Are the methodology and assumptionsperiodically reviewed by an independentsource or function?

f. Has the banking organization consideredthe feasibility of using other types ofinternal modeling methodologies (includ-ing non-VaR methods), such as historical-scenario analyses or stress tests, for mea-suring the risk of equity investments anddetermining regulatory capital charges?

9. Discuss the impact of regulatory capitalrequirements on portfolio and risk-management activities with the bankingorganization’s management team. Ensure thatmanagement has established an appropriateinfrastructure to meet regulatory capitalrequirements.

RISK MANAGEMENT

1. Assess the adequacy of the banking organi-zation’s policies, procedures, systems, andinternal controls in light of the complexityand risk profile of the institution’s equityinvestment activities. Determine whetherthese policies, procedures, systems, and con-trols are reasonably designed to—a. delineate the types and amounts of invest-

ments that may be made;b. provide guidelines on appropriate hold-

ing periods for different types ofinvestments;

c. establish parameters for portfoliodiversification;

d. monitor and assess the carrying value,market value, and performance of eachinvestment and the aggregate portfolio;

e. identify and manage the market, credit,concentration, and other risks;

f. identify, monitor, and assess the terms,amounts, and risks arising from transac-tions and relationships (including contin-gent fees or interests) with each com-pany in which the banking organizationholds an interest;

g. ensure the maintenance of corporate sepa-rateness between the banking organiza-tion and each company in which thebanking organization holds an interestunder merchant banking authority, and

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protect the banking organization and itsdepository institution subsidiaries fromlegal liability for the operations con-ducted by and financial obligations ofeach such company; and

h. ensure compliance with laws and regu-lations governing transactions and rela-tionships with companies in whichthe banking organization holds an interest.

2. Determine how risk exposures are aggre-gated on a consolidated basis at the bankholding company level. Determine howequity-ownership positions are aggregatedif nontrading equity investments are madein other areas across the consolidated orga-nization. Request a copy of any aggregationreports.

3. Review any internal audits, regulatoryexaminations, consultant reports, or otherthird-party reviews to identify significantsupervisory issues.

4. Identify the investment strategy and whetherit is consistent with the institution’s riskprofile and overall investment strategy.

5. Review and assess the adequacy and com-pleteness of the investment process byreviewing investment memoranda, due-diligence reviews, and periodic portfolioreviews for information, including—a. an overall description of the investment,

which generally includes the nature ofthe business and type of securities held;

b. financial condition and trends; andc. the current valuation, exit strategies, the

internal rate of return (IRR), and riskrating.

6. Assess the reasonableness of exit strategiesfor the investments reviewed.

7. If the banking organization is engaged infund-management activities, assess therobustness of the following:a. the limited-partner due-diligence pro-

cess, including suitability analysesb. the review of fund documentation by

outside legal counsel with sufficientexperience in such activities

c. operational processing capabilities andlimited-partner reporting capabilities

d. the level of due diligence performed onthird parties responsible for operationalor reporting functions

8. If the banking organization acts as a generalpartner for private equity funds or sponsorsfunds of funds, determine the following:a. What is the business objective and strat-

egy for launching limited partnerships orfunds of funds?

b. How is the fund (or funds) structured?Who is the general partner?

c. What are the investment objectives(review a sample of private-placementmemoranda)? Are the reviewed samplesconsistent with stated objectives?

d. Does management understand the risksof launching limited partnerships or fundsof funds?

e. Does management use qualified internalcounsel or retain outside counsel toensure compliance with securities laws?

f. Who is the client base for limited part-nerships or funds of funds (that is, towhom are these funds marketed)? Whatis the process for determining investorsuitability?

g. Has the firm experienced any investordefaults on fund capital calls?

h. Is the administration of funds of fundsperformed in-house or outsourced? Ifoutsourced, has management establishedprocedures for and does it perform aperiodic review of the provider? Howextensive is the provider’s client base?

i. How robust are the fund-of-funds selec-tion and due-diligence processes? Whatis the valuation methodology for thefunds?

j. How are management fees generated onthe banking organization’s limited part-nership or fund-of-funds activities?

9. Assess the robustness of the banking orga-nization’s risk-exposure measurement capa-bilities. Determine whether market sce-narios employed for risk-exposuresimulations of equity investments are con-sistent with those used in broader corporatemarket-risk modeling. Does the bankingorganization periodically stress-test the port-folio (or portfolios) to estimate the worst-case-scenario risk exposure in its portfolio?

10. Review the banking organization’sinvestment-approval process to ensure thatit is consistent with board-approved poli-cies, procedures, limits, and supervisoryguidance (such as in SR-00-9) and that it isappropriately documented.

11. Obtain and review formal hedging policies.The policies should include descriptions ofapproved hedging instruments for specifichedging strategies, definitive performance-related objectives, and appropriate risk

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parameters, including both market- andcredit-risk exposure.

12. If applicable, determine whether hedgescomply with Statement of Financial Account-ing Standards No. 133 (FAS 133), asamended by Statement of Financial Account-ing Standards Nos. 137 and 138 (FAS 137and FAS 138). Correlation between thederivative and the investment (or invest-ments) to be hedged should be well docu-mented and periodically validated by inde-pendent, external audits.

13. Assess the adequacy of management infor-mation systems (MIS), including systemsfor mark-to-market valuation of the hedginginstruments, the premium amortization ofpurchased instruments, and performanceevaluation.

14. If hedging strategies are developed andexecuted at the business unit, assess thebackground and experience level of staffwho conduct these activities.

15. Obtain documentation summarizing thebanking organization’s MIS capabilities,including schematic diagrams, where avail-able, to identify the level of automation andrequired manual processing. If MIS reportsare generated manually, has the firm estab-lished a control process to ensure the integ-rity of the data in the reports?

16. Assess whether MIS is sufficiently robustfor the size and complexity of the bankingorganization’s investment activities. Doesthe management information system appro-priately monitor and report on all materialrisks?

17. Determine whether the banking organiza-tion’s MIS capabilities allow for tracking ofownership and risk exposures across enti-ties in which equity investment activitiesare booked or conducted.

18. Identify and assess the level of MIS inte-gration with corporate systems. Does theequity investment system feed into the cor-porate general-ledger system or is manualintervention required?

19. If applicable, request a demonstration of theMIS capabilities, including the variousfunctions supporting a representativetransaction.

20. Determine if management has establishedfollow-up or escalation procedures to beimplemented if management reportsindicate emerging problems or abnormalconditions.

21. If the banking organization has launched afund of funds, and if the reporting functionfor the fund is outsourced, review vendorreports for timeliness, accuracy, andcompleteness.

COMPENSATIONARRANGEMENTS

1. Assess whether clear policies and proceduresare in place to govern compensation arrange-ments, including the co-investment structureand the terms and conditions of employeeloans.

2. Determine if the co-investment partnershipparticipates in every direct investment of theprivate equity subsidiary.

3. Determine the appropriateness of the repay-ment terms for any co-investment-plan bor-rowings. The loan should be serviced beforeany distributions are made to the co-investment partnership.

4. If the investments in the private equity port-folio are hedged, determine whether theco-investment-plan investments are similarlyhedged.

5. If there are other forms of compensationbesides a co-investment plan, determineif compensation is based on performancelevels or operating results. Also determine ifresults are based on realized or unrealizedgains and whether compensation incentivesencourage the conduct of equity investmentoperations in a manner consistent with theinstitution’s risk appetite. The income state-ment should be closely reviewed to deter-mine what the firm represents are profits ofthese investments.

NONINVESTMENTTRANSACTIONS

1. Determine the extent to which the institutionis engaged in lending or other noninvestmenttransactions with portfolio companies or withprivate equity fund managers or general part-ners of portfolio companies, including deriva-tive transactions with or guaranteed by port-folio companies and general partners.Determine whether these transactions areconducted on terms and conditions that are

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appropriate and reasonable from the stand-point of the institution.

2. Determine whether lending and other busi-ness transactions between an insured deposi-tory institution and a portfolio company thatmeets the definition of an affiliate complywith sections 23A and 23B of the FederalReserve Act.

3. Determine whether the bank holding com-pany has systems and policies in place tomonitor transactions between the holdingcompany, or a nondepository institution sub-sidiary of the holding company, and a port-folio company, including limits on exposuresof the holding company on a consolidatedbasis to a single portfolio company.

DISCLOSURE OF EQUITYINVESTMENT ACTIVITIES

1. Determine the completeness and appropriate-ness of the institution’s public disclosuresof its equity investment activities, in light ofthe materiality and risk profile of theseactivities.

2. Advise management of any material con-cerns regarding the sufficiency of disclosureand encourage consultation with qualifiedsecurities counsel, as appropriate.

Equity Investment and Merchant Banking Activities—Examination Procedures 3040.3

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