Dear Mr. Huffstutler:

This is in response to the request by Bank of America Corporation ("BofA"), Charlotte, North Carolina, for an exemption from section 23A of the Federal Reserve Act and the Board's Regulation W for transactions in which Bank of America, N.A. ("Bank") borrows securities from U.S. broker-dealer subsidiaries of BofA ("Affiliated Broker-Dealers").¹

Background

Bank engages in a wide variety of equity derivative transactions with customers. Certain of Bank's equity derivative transactions result in Bank's having a synthetic long position in one or more underlying equity securities. In some of these cases, Bank's hedging methodology requires Bank to enter into short sales in the underlying equity securities. Bank typically establishes these short sales by borrowing the securities it sells short (the "Borrowed Securities"). ²

Bank's general practice is to enter into these securities borrowing transactions with Affiliated Broker-Dealers. Bank has indicated that it chooses to borrow securities from Affiliated Broker-Dealers (rather than from an unaffiliated securities lender) to maintain the confidential and proprietary nature of Bank's hedging activities and to enable Bank to access the operational and systems capabilities of Affiliated Broker-Dealers (instead of having to develop its own securities borrowing infrastructure).

Bank borrows securities from Affiliated Broker-Dealers under a written securities borrowing agreement. Under this agreement, Bank must post collateral to an Affiliated Broker-Dealer -- usually in the form of cash, but sometimes in the form of other securities or letters of credit -- to secure Bank's obligation to return the Borrowed Securities. The value of the collateral posted by Bank must equal a certain minimum percentage (the "margin percentage") of the value of the Borrowed Securities. The margin percentage ranges from 100 to 105 percent, depending on the nature of the collateral and the Borrowed Securities. In the vast majority of cases, including the typical case in which Bank borrows a U.S. equity security secured by U.S. dollars or U.S. Treasury securities, the margin percentage is 102 percent. Bank has represented that both the form and amount of collateral posted by Bank are customary for securities borrowing transactions between unaffiliated counterparties.

The cash collateral typically provided by Bank in a securities borrowing transaction is not held by the Affiliated Broker-Dealer in a segregated account during the term of the transaction. Instead, the Affiliated Broker-Dealer usually repledges the cash collateral to secure a contemporaneous and parallel borrowing of the Borrowed Securities from a nonaffiliate. Although the Affiliated Broker-Dealer typically uses the cash collateral obtained from Bank to post collateral for a parallel securities borrowing transaction, the cash is legally available to meet the general funding needs of the Affiliated Broker-Dealer.

During the term of the securities borrowing transaction, Bank marks the Borrowed Securities and any collateral to market on a daily basis and calls on a daily basis for the return of collateral to the extent that the value of the collateral exceeds the agreed-on margin percentage of the value of the Borrowed Securities.³ Bank may terminate a securities borrowing transaction on any business day by returning the Borrowed Securities to the Affiliated Broker-Dealer, and the Affiliated Broker-Dealer may terminate a transaction by giving Bank three business days' prior notice.

Legal Analysis

Section 23A and Regulation W limit the aggregate amount of "covered transactions" between a bank and any single affiliate to 10 percent of the bank's capital stock and surplus, and limit the aggregate amount of covered transactions between a bank and all its affiliates to 20 percent of the bank's capital stock and surplus.⁴ "Covered transactions" include the purchase of assets by a bank from an affiliate, the extension of credit by a bank to an affiliate, the issuance of a guarantee by a bank on behalf of an affiliate, and certain other transactions.⁵ In addition, the statute and rule require a bank to secure its extensions of credit to, and guarantees on behalf of, affiliates with prescribed amounts of collateral.⁶ Section 23A and Regulation W also authorize the Board to exempt, at its discretion, transactions or relationships from the requirements of the statute and rule if the Board finds such exemptions to be in the public interest and consistent with the purposes of section 23A.⁷

The securities borrowing transactions are covered transactions under section 23A and Regulation W and, consequently, are subject to the quantitative limits and collateral requirements contained in the statute and rule. A bank's collateralized borrowing of securities from an affiliate generally is an extension of credit by the bank to the affiliate for purposes of section 23A and Regulation W. Although section 23A does not define "extension of credit," Regulation W defines "extension of credit" to include (i) a bank's "extending of credit in any manner whatsoever" and (ii) transactions "as a result of which an affiliate becomes obligated to pay money (or its equivalent) to a bank."⁸ The securities borrowing transactions between Bank and the Affiliated Broker-Dealers result in an affiliate's receiving money (or U.S. government obligations) from Bank at inception and incurring an obligation to pay the money (or U.S. government obligations) back to Bank at termination. Accordingly, the transaction falls within the literal terms of the definition of extension of credit to an affiliate under Regulation W.

Moreover, the transactions impose risks on Bank that are almost indistinguishable in nature from the risks associated with a secured extension of credit by a bank to an affiliate. Throughout the term of these transactions, Bank occupies a position where it stands to lose the difference between the amount of cash (or U.S. government obligations) transferred to the Affiliated Broker-Dealer and the liquidation value of the equity securities transferred to Bank if the Affiliated Broker-Dealer becomes insolvent or otherwise defaults on its obligation to return the cash (or U.S. government obligations) to Bank. Bank's exposure is no different in nature than the exposure Bank would have in an ordinary loan of cash to an affiliate that is collateralized by equity securities.

The Exemption

After reviewing the matter, and in light of the circumstances and conditions described in this letter, the Board believes that granting an exemption would be appropriate.⁹ The Board notes that it previously has granted an exemption from the requirements of section 23A for transactions in which a bank lends securities to an affiliate.¹⁰

First, in order to allow accurate monitoring of Bank's exposure to affiliates and to limit Bank's unsecured exposure to affiliates, Bank must continue to mark to market its securities borrowing transactions with Affiliated Broker-Dealers on a daily basis, and the securities borrowing transactions must continue to be subject to daily margin maintenance requirements. These requirements would ensure that Bank's exposure on a securities borrowing transaction with an Affiliated Broker-Dealer would be limited to (i) the amount by which the value of the collateral must exceed the value of the Borrowed Securities (usually 2 percent of the value of the Borrowed Securities) plus (ii) the amount by which the value of the collateral might further exceed the value of the Borrowed Securities between the last remargining event and the time when Bank is able to liquidate Borrowed Securities after a default by an Affiliated Broker-Dealer.¹¹

Second, in order to enhance the ability of Bank to determine the mark-to-market value of the Borrowed Securities and to facilitate any efforts by Bank to liquidate the Borrowed Securities if an Affiliated Broker-Dealer defaults, the exemption would be available only for transactions involving Borrowed Securities that have a "ready market," as defined in the net capital rule of the Securities and Exchange Commission ("SEC").¹² Under the SEC's interpretations of the net capital rule, U.S. equity securities have a "ready market" if they are traded on a U.S. securities exchange or NASDAQ, or are OTC securities quoted by independent market makers in an interdealer network.

In addition, Bank would be required to treat a portion of each securities borrowing transaction with an affiliate as nonexempt. Specifically, the nonexempt covered transaction amount would be equal to (i) Bank's current unsecured exposure ("current exposure") to Affiliated Broker-Dealers in securities borrowing transactions plus (ii) an estimate of Bank's potential future exposure ("PFE") to Affiliated Broker-Dealers in the transactions.¹³ Bank's current exposure to Affiliated Broker-Dealers in securities borrowing transactions would equal the difference between the cash amount (or current market value of securities) posted as collateral by Bank and the current market value of the Borrowed Securities. Bank's PFE to Affiliated Broker-Dealers in securities borrowing transactions initially would be fixed at 6 percent of the current market value of the Borrowed Securities,¹⁴ but Bank may ultimately use an internal model to measure PFE or overall exposure for these transactions with the approval of Federal Reserve System and OCC staff.

To address the potential that this exemption might facilitate Bank's structuring loans to affiliates in the form of securities borrowing transactions, the exemption would be available only if the Affiliated Broker-Dealer executes a securities borrowing transaction with an unaffiliated counterparty that is substantially contemporaneous with and on the same basic terms as the Bank's securities borrowing transaction with the Affiliated Broker-Dealer. The purpose of this requirement is to ensure that exempt securities borrowing transactions are bank-driven rather than affiliate-driven; that is, that securities borrowing transactions are not used to finance the preexisting securities inventory of an Affiliated Broker-Dealer.

To enhance the ability of Bank to close out securities borrowing transactions if an Affiliated Broker-Dealer becomes insolvent, Bank currently documents these transactions as securities contracts for purposes of section 555 of the Bankruptcy Code.¹⁵ This practice should facilitate the ability of Bank to liquidate these transactions promptly after the commencement of an insolvency proceeding with respect to the Affiliated Broker-Dealer.¹⁶ To qualify for the exemption, Bank would have to continue this practice.

Bank would continue to be subject to the market terms requirement of section 23B of the Federal Reserve Act in its securities borrowing transactions with affiliates. Section 23B requires that these transactions be on terms that are substantially the same, or at least as favorable to the bank, as those prevailing at the time for comparable transactions with unaffiliated companies .¹⁷

Granting the exemption would have several public benefits. The exemption would increase the equity derivative opportunities of Bank customers, lower the price of equity derivatives for Bank customers, and, hence, increase the ability of Bank customers to hedge their own risks of operations or investments.

Conclusion

In light of these considerations and all the facts you have presented, the transactions appear to be consistent with safe and sound banking practices and the purposes of section 23A. Accordingly, the Board hereby grants the requested exemption subject to the conditions and limits discussed above. This exemption also is available to BofA's other subsidiary banks, subject to the condition that those transactions are on the same terms as those between Bank and the Affiliated Broker-Dealers, including the terms and conditions outlined in this letter.

This determination is specifically conditioned on compliance by BofA and Bank with all the commitments and representations they made in connection with the exemption request. These commitments and representations are deemed to be conditions imposed in writing by the Board in connection with granting the request and, as such, may be enforced in proceedings under applicable law. This determination is based on the specific facts and circumstances of the securities borrowing transactions described in your correspondence and this letter. Any material change in those facts and circumstances or any failure by BofA or Bank to observe any of its commitments or representations may result in a different view or in a revocation of the exemption.

Very truly yours,

[signed] Robert deV. Frierson

Robert deV. Frierson
Deputy Secretary of the Board