Client Alert

The OCC and the Future of Principal-Protected Products in Hedge Fund Transactions


On September 7, 2004, the Office of the Comptroller of the Currency ("OCC") issued its Interpretive Letter 1010 ("IL1010").[1]  IL1010 deals with the authority of a national bank (the "Bank") and its wholly-owned operating subsidiary ("Operating Subsidiary") to issue financial warranties in connection with a particular mutual fund (the "Mutual Fund").  The purpose of the financial warranties, as stated in IL1010, was to "guarantee that the investment structuring advice and monitoring services provided by the Bank to the Mutual Fund will perform as designed".[2]  In turn, investors in the Mutual Fund would receive a full guarantee of their principal, plus a minimum annual return, based on the financial strength of the Operating Subsidiary and, via a back-to-back financial warranty, the Bank.[3]  At issue was whether the financial warranties constituted permissible guarantees under interpretive ruling 12 C.F.R. § 7.1017.[4]

The purpose of this article is to analyze the OCC’s reasoning in IL1010 and to determine its applicability to hedge fund principal-protected products.[5]  Given the proliferation of such products with varied nomenclature (e.g., options,  stop-loss strategies, constant proportion portfolio insurance), national banks involved in structuring and issuing such products should consider the principles set forth in IL1010 and, with the help of experienced legal counsel, determine whether such products comply with the OCC’s "substantial interest" parameters.

National Bank Guarantees

As noted in IL1010, "the general rule oft-cited in [case law on national bank guarantees] is that it is ultra vires[6] for a national bank to guarantee the obligations of others, but there have been many exceptions"[7].  Although the National Bank Act is silent on the authority of national banks to provide guarantees[8], the case law that has developed in this area has tended to support the notion that the issuance of a guarantee that is incidental to other authorized banking activity is within a national bank’s authority[9].

The "Substantial Interest" Analysis

Most of the analysis contained in IL1010 relates to how the financial warranties issued by the Bank and the Operating Subsidiary satisfy the relevant criteria set forth in 12 C.F.R.
§ 7.1017 relating to a "substantial interest." 12 C.F.R. § 7.1017 provides in relevant part that "[a] national bank may lend its credit, bind itself as a surety to indemnify another, or otherwise become a guarantor [emphasis supplied]…if: (a) The bank has a substantial interest in the performance of the transaction involved …"[10]. In other words, if a bank is involved in a permissible activity and if the guarantee in question furthers the bank’s interest in such transaction, the guarantee itself is incidental to the authorized activity and meets the "substantial interest" requirement contained in 12 C.F.R. §7.1017.  The guarantee alone cannot serve to create the "substantial interest".

Relevance of the Bank’s Role in the Underlying Transaction

Underlying the OCC’s analysis in IL1010 is the notion that the financial warranties guarantee that the investment structuring advice and monitoring services provided by the Bank to the Mutual Fund will perform as designed[11]. The OCC noted that the Bank was instrumental in creating and implementing the Mutual Fund[12] and that its involvement with the Mutual Fund extended to structuring the investment program, allocation models and defeasance triggers integral to the Mutual Fund’s financial structure and performance[13]. In addition, the OCC reasoned that the Bank had also provided an evaluation of the financial risks and related considerations involved in issuing the financial warranty, noting that the Bank’s exposure in providing the financial warranty was virtually non-existent[14].  Because of the Bank’s initial and continuing role with respect to the Mutual Fund’s operation, the OCC determined that the financial warranties effectively amounted to a guarantee of the Bank’s own financial advisory activities relating to the Mutual Fund- a role certainly permissible for national banks and their operating subsidiaries[15].

Moreover, the OCC described "the Bank’s ability to sell the larger package of banking activities associated with the ‘principal protected’ model to independent mutual funds" as "enhanced by the Bank’s ability to provide the protection related to the [Mutual] Fund’s ultimate performance."[16]  Reasoning that the financial warranties served to ensure that the Bank’s models, structuring advice and asset allocation methodology worked as represented to the Mutual Fund and its investors[17], the OCC concluded that the Bank’s issuance of its financial warranty "advances the Bank’s own interest in providing financial activities related to principal protected funds and is not merely an interest created by the guarantee [i.e., the financial warranty] itself"[18].  Subject to satisfying the safeness and soundness principles for activities undertaken by banks generally, the OCC determined that the Bank’s and the Operating Subsidiary’s issuance of their respective financial warranties was permissible under the circumstances of the described transaction.

The Safeness and Soundness Principle

IL1010 ends with a discussion of the conformity of the financial warranties with safe and sound banking practices[19]. The OCC emphasized the necessity of  the Bank’s  internal controls and risk measurement procedures relative to the complexity and sophistication of the underlying transaction, citing systemic elements required to make the activity appropriate from a risk management standpoint[20].  A failure by the Bank to demonstrate that it had the requisite controls in place for such a complex financial transaction would mean that the OCC could not opine as to the legal permissibility of the financial warranties. As a result, the OCC conditioned its otherwise positive decision on the OCC’s supervisory staff’s "concluding that the Bank has such risk measurement and management processes in effect with respect to its financial warranty product."[21]

Does IL1010 Apply to Principal Protected Hedge Fund Transactions?

Strictly speaking, no.  OCC interpretive letters are issued on a case-by-case, fact-specific  basis and do not have any precedential value.  However, the analysis in IL1010 is certainly persuasive and reflects certain probabilities in the OCC’s response in an analogous situation involving a national bank’s issuance of a guarantee-like product (typically, a derivative or a medium-term debt instrument) affording capital protection in a structured alternative investment transaction.

Involvement of Providers in the Structuring Process

Because the OCC’s reasoning in IL1010 relied so extensively on the Bank’s involvement in the structuring and monitoring processes of the Mutual Fund, it is useful to consider the technology involved in capital-protected hedge fund transactions and a provider’s role in structuring such mechanics.  Although current products range from relatively simple call options to quite complex dynamic allocation strategies, all of such products involve a significant amount of investment structuring advice, and many require ongoing asset allocation monitoring[22].  If anything, the world of structured alternative investment products requires an even greater sensitivity to risk/return modeling than the arena of principal-protected mutual funds, given the unique characteristics of hedge funds[23]. As a result, the structuring advice and asset allocation considerations present in the mutual fund transaction described in IL1010 would be of even greater concern in the structured alternative investment arena.  At the risk of having to provide investors with the expected financial result, a bank involved in a capital-protected hedge fund transaction would be very hands-on in ensuring that a fund of funds will perform as expected through the implementation of portfolio requirements and pre-determined defeasance triggers.

Adding a Leverage Component

However, it is worth noting that a number of these structures also contain a leveraging feature as well as a simple capital protection component. Such leveraging of positions in a hedge fund of funds  (i.e., an investment vehicle that invests in more than one hedge fund, thereby allowing for greater diversification in alternative investment strategies) through a hedge fund-linked derivative is easy and relatively inexpensive, compared with a traditional bank lending arrangement. Could the inclusion of a leveraging feature change the analysis employed by the OCC in IL1010 where hedge fund products are concerned? Because the emphasis in IL1010 is on the nexus between the bank permissible activity and the guarantee in order to satisfy the "substantial interest" test[24], one should surmise that the de facto making of a loan through the leverage feature, which is certainly a bank permissible activity[25], coupled with a principal protection provider’s involvement in structuring the leverage overlay, would have only a positive impact on the "substantial interest" analysis. Thus, adding leverage would appear to be a positive, or, at worst, neutral, factor in assuring the permissibility of a national bank’s issuance of a principal protected hedge fund product.

Disintermediated Structures

A number of structured alternative investment products involve two tiers of capital protection, whereby the first-tier provider sheds all or a portion of its exposure to a second-tier provider[26]. In such cases, the identity of the second-tier provider is typically shrouded from the investors receiving the benefit of principal protection, with investors relying on the credit support afforded only by the first-tier provider. However, in such situations, both tiers of providers are usually significantly involved in the structuring and monitoring process, even if the transaction sponsor or beneficiaries of the protection are unaware of the nature and extent of the lower-tier provider’s role. Since the second-tier provider is at risk (to the extent of its agreed-upon coverage) to the fund of funds’ investment program, it has an interest in being actively involved in structuring the allocation methodology and on-going monitoring requirements of the capital-protected transaction[27].

 As for the first-tier provider, although it is merely an intermediary to the extent of the exposure transferred to the second-tier provider, it also has a significant interest in actively structuring and monitoring the underlying investment program.  In the first place, it may not have shed all of its risk to the second-tier provider.  In the second place, the contract between the first-tier provider and second-tier provider will have some termination triggers that operate independently of the underlying transaction (e.g., those related to the status or performance of the second-tier provider itself).  Thirdly, it may act as a distributor of securities issued by the fund of funds or as an arranger, together with the investment manager, of the investment program generally. In any case, it would seem that the principal protection product is sufficiently incidental to the provider’s other activities so as to conclude that a provider has a "substantial interest" in the performance of the underlying transaction under the standards of §7.1017 of the National Bank Act.


Based on the foregoing analysis of IL1010, it would seem that national banks interested in providing capital-protection products in hedge fund-linked transactions would satisfy the "substantial interest" test set forth in the National Bank Act.  However, a few points are worth noting.  The first is that IL1010 applies only to national banks and thus does not address scenarios where principal protection is to be provided by state or foreign banks or non-bank guarantors[28]. The second is that satisfying the "substantial interest" condition is not dispositive of whether the underlying transaction is a bank permissible activity or whether a  provider’s structuring and monitoring activities are "safe and sound" banking practices. Thirdly, IL1010 by its express terms does not deal with the risk-based capital treatment of principal protected products[29], a key consideration in matters of regulatory accounting and pricing, among other concerns.  Finally, because the analysis is fact-specific, it is unclear whether the existence or non-existence of certain circumstances would result in the opposite conclusion, namely, that the principal protection is nothing more than a pure guarantee and therefore void as an ultra vires contract.

Despite all of the foregoing concerns, capital-protected structures in hedge fund transactions continue to grow and thrive.  It is my view that, for so long as hedge funds continue to be perceived as exotic, risky and misunderstood asset classes, the structured alternative investments world will have a need for sophisticated, innovative "structuring advice and monitoring services"[30] provided by financial institutions with expertise in this area. What IL1010 tells us is that if a national bank "puts its money where its mouth is" by backing its advice with its own credit, it will have changed the essential character of an otherwise questionable guarantee into an assurance of its role as a financial product consultant. Depending on a variety of factors- among them, the performance of equity markets, interest rate environment, protection provider and investment manager track records and rate of innovation to meet the market’s evolving needs- the halcyon days of capital-protected hedge fund products may be still to come.


[1] OCC Interpretive Letter No. 1010, September 7, 2004, reprinted in [Current Binder] Fed. Banking L. Rep. (CCH) ¶ 81‑539 at 90,216 ("Interpretive Letter No. 1010").

[2] Id. at 90,216.

[3] Id. at 90,216-90,217.

[4] Id. at 90,217.

[5] This article uses "capital-protected" and "principal-protected" interchangeably.  Although "principal-protected" is the term most often used in the mutual fund and hedge fund industries, "capital-protected" may be a more accurate reflection of the securities afforded the benefit of the protection, which are often equity securities.

[6] Unauthorized; beyond the scope of power allowed or granted by a corporate charter or by law.  Black’s Law Dictionary 1559 (Bryan A. Garner ed., 8th ed, 1999).  An ultra vires contract of a national bank is void, but recovery will be permitted on an implied contract to restore benefits received.  Such federal rule will be applied when a national bank is sued in state court.  O’Connor v Bankers Trust Co. 159 Misc. 920 (Sup. Ct. N.Y. County 1936), 289 N.Y.S. 252, aff’d, 253 A.D. 714, 1 N.Y.S. 2d 641 (1st Dep’t 1937), aff’d 278 N.Y. 649, 16 N.E. 2d 302 (N.Y. 1938).

[7] Interpretive Letter No. 1010 at 90,217.

[8] Id.  See also 12 U.S.C. § 24 (Seventh).

[9] Id.

[10] 12 C.F.R. § 7.1017(a).

[11] Interpretive Letter No. 1010, at 90,216.

[12] Although IL1010 is silent on this point, this article assumes that the Mutual Fund is not an affiliate of the Bank for purposes of §23A of the Federal Reserve Act (12 U.S.C. §371c) , which places qualitative and quantitative restrictions on extensions of credit by a federally insured depository institution to its affiliates.

[13] Id. at 90,218.

[14] Id.  In footnote 25 of Interpretive Letter 1010, the OCC notes that "The Bank’s exposure from the principal protected [Mutual] Fund is small.  The Bank represents that because of the nature of the investments the credit risk is virtually zero and the market risk is minimized to a low level within certain defined parameters."

[15] Interpretive Letter No. 1010, at 90, 219

[16] Id. at 90, 219.

[17] Id.

[18] Id.

[19] A safe and sound banking practice is conduct that follows the accepted standards of banking operations (First Nat’l Bank v. Comptroller of Currency, 697 F.2d 674).  Congress has given the Comptroller broad authority to ensure that all national banks follow safe and sound banking practices (Golden Pacific Bancorp v. Clarke, 267 U.S. App. D.C. 86).  The Comptroller has discretionary power to determine what constitutes an "unsafe or unsound practice" and is authorized to order banks and their directors to cease and desist from any violations of law or "unsafe or unsound practice 12 U.S.C. § 1818(b)91) (Abercrombie v. Clarke, 920 F.2d 1351).  The courts have held the following to be contrary to safe and banking practices: (i) to operate without adequate capital; (ii) to fail to obtain and maintain current and satisfactory credit information on a significant volume of its extensions of credit; (iii) to grant credit in significant amounts which were not fully supported by all necessary collateral documentation; (iv) to fail to maintain a loan loss reserve at realistic and adequate levels; and (v) to fail to implement and adhere to procedures to limit, control and document contingent liabilities on unfunded loan commitments and letters of credit (First Nat’l Bank v. Comptroller of Currency, 697 F.2d 674; Professional Asset Mgmt. v. Penn Square Bank, N.A., 1986 U.S. Dist. LEXIS 16487).

[20] Interpretive Letter No. 1010 at 90,219.

[21] Id.

[22] In particular, structures that track the prices of zero-coupon instruments without an actual purchase of the instrument allow for a dynamic re-allocation of capital between the underlying hedge fund investment and the cash/cash equivalent component.  This structure, known as constant proportion portfolio insurance, allows for the potential of leveraged returns if the hedge fund investment performance exceeds a certain threshold.

[23] Such characteristics include a lack of transparency and disclosure, the relatively small size of funds and the lax regulatory environment.  See Mehraj Mattoo, Structured Alternative Investment Products, in, Funds of Hedge Funds:  For Professional Investors and Managers  (Sohail Jaffer ed., 2003).

[24] Interpretive Letter No. 1010 at 90,218.

[25] This article does not address leverage limits with respect to certain regulated activities, e.g. purpose credit relating to the acquisition of margin stock.

[26] Yurke, Alice, Principal Protection Products:  Possibilities and Perils from a Legal Perspective, Bank Accounting & Finance v.16 (Aug. 2003):13.

[27] In addition, safety and soundness considerations (see footnote 19) would require such risk management controls and ongoing oversight in the case of all national banking institutions.

[28]IL1010 would only be applicable (subject to the limitations on the precedential value of OCC interpretive letters generally) to national banks and federally-licensed branches and agencies of foreign banks, unless state laws specifically grant to state banks the powers granted to national banks by law, regulation or interpretation.

[29] Interpretive Letter No. 1010 at 90,219.

[30] Id. at 90,216.




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