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proposing to acquire Dreyfus as an operating subsidiary. The safety and soundness, deposit insurance, and customer protection concerns relating to the mutual fund activities of Dreyfus are similar to those involved in other operating subsidiary proposals involving mutual fund activities that the OCC has approved, but the OCC has never approved an acquisition of this magnitude involving mutual fund activities.'

Some of the risks we focus on in reviewing proposed mutual fund activities include operational, regulatory compliance, legal and financial exposure risks.' Operational risks may arise from the high volume of mutual fund transactions and the often complicated nature of these transactions. Banks or operating subsidiaries must have adequate technology, personnel, and internal controls to manage this exposure. Regulatory compliance risks also may increase because of the bank's obligation to assure compliance with a number of laws and regulations issued by the OCC, Securities and Exchange Commission (SEC), Internal Revenue Service and National Association of Securities Dealers (NASD). Legal risks may

'National banks have been involved in the management and marketing of mutual funds and pooled accounts for many years. National banks and their subsidiaries may provide investment advice to mutual funds and to customers, may broker mutual funds, may advertise and market their services and may provide a range of administrative services to mutual funds. Administrative services include acting as transfer agent, custodian, and registrar, and providing record-keeping, accounting, and related services. See, e.g., OCC Letter No. 625 (July 1, 1993); OCC Letter No. 622 (April 19, 1993); letter dated January 13, 1993 from Daniel L. Pearson to David E. Johnson; letter dated March 26, 1990 from J. Michael Shepherd to Kenneth L. Bachman, Jr.; letter dated January 14, 1988 from William B. Glidden to Burton L. Raimi, Esq.; OCC Letter No. 403 (December 9, 1987), reprinted in Fed. Banking L. Rep. ↑ 85,627 (CCH); OCC Letter No. 386 (June 19, 1987), reprinted in Fed. Banking L. Rep. ↑ 85,610 (CCH); OCC Letter No. 367 (August 19, 1986), reprinted in Fed. Banking L. Rep. 85, 537; OCC Letter No. 363 (May 23, 1986), reprinted in Fed. Banking L. Rep. 1 85,533 (CCH); OCC Letter No. 332 (March 8, 1985), reprinted in Fed. 85,502 (CCH); OCC Letter No. 329 (March 4, 1985), reprinted in Fed Banking L. Rep. 1 85,499 (CCH); letter dated May 9, 1984 from Peter Liebesman to Edward J. McAniff, Esq. Many of these activities have also been approved for bank holding company subsidiaries by the Federal Reserve Board. See Mellon Bank Corporation, 79 Fed. Res. Bull. 626 (1993).

Banking L. Rep. 1

Another factor we consider is the capital levels of the bank and the proposed operating subsidiary. Mellon represents that capital considerations support placement of the proposed mutual fund activities within an operating subsidiary of the bank, rather than in an affiliate. Mellon has stated that its desire to place Dreyfus in an operating subsidiary is premised on the significant capital and earnings benefits for Mellon. The OCC will carefully consider the consequences of the structure of the proposed transaction for the capital position of both Mellon and Dreyfus.

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arise from potential litigation by customers based on a bank's noncompliance with legal requirements. Finally, when a bank assumes multiple responsibilities relating to mutual funds, financial loss may result if proper controls are not in place. For example, banks that are both investment adviser and sales agent for mutual funds need adequate controls to ensure appropriate ethical, suitability and disclosure standards in selling mutual fund shares to the retail public. It is important to note that the risks that arise from bank involvement in mutual fund activities are not new but already exist in a wide variety of money management and sales activities in which many banks engage. Nonetheless, banks may need enhanced controls and systems to mitigate the increased risk levels resulting from increased involvement in the mutual funds business.

In reviewing the Mellon/Dreyfus proposal, we will evaluate the reasonableness and appropriateness of the proposed risk management controls presented by the management and the board of Mellon and examine controls governing the relationship between Mellon and Dreyfus. For example, we will assess the adequacy and independence of control systems such as management and board oversight, business plans and strategies, written policies and procedures, audit programs and compliance systems. We will not permit the transaction to go forward unless we are satisfied that appropriate controls are in place.

After the OCC concludes its review of the notice, the agency will decide, based on the particular facts, whether to approve the proposal and, if the decision is to approve, what conditions would be appropriate to address any risks and concerns raised by the considerations outlined above. We would not approve this or any other transaction unless we were confident that safety and soundness, customer protection, and conflict of interest concerns had been addressed, either through voluntary commitments on the part of the institutions involved or through formal conditions imposed by the OCC, as appropriate.'

In developing appropriate conditions, we will consider the conditions that have been imposed by the Federal Reserve Board, as well as the OCC, on similar transactions in the past. For example, in recent operating subsidiary filings relating to mutual fund activities, the OCC has imposed a range of investor protection conditions (including disclosure and other marketing and sales limitations), capitalization requirements for the subsidiaries, lending limits on bank/subsidiary transactions, operating controls, and a prohibition on engaging in any new activities without notifying the OCC. See OCC Letter No. 625; OCC Letter No. 622. The Federal Reserve Board has imposed similar restrictions on its approval of applications by

'A range of statutory and regulatory provisions already govern bank mutual fund activities and address some potential conflicts of interest and safety and soundness concerns. For example, the Investment Company Act provisions apply to mutual funds and their investment advisers, including national banks. Sections 23A and 23B of the Federal Reserve Act apply to transactions between mutual funds and national bank investment advisers to the funds. The Investment Advisers Act applies to a national bank operating subsidiary engaged in providing investment advice.

bank holding companies to engage in activities related to mutual funds. See, e.g., Mellon Bank Corporation, 79 Fed. Res. Bull. 626 (1993).

We will also evaluate the adequacy of the voluntary commitments made in the notice. Mellon has committed to adopt a Policy Statement that contains policy guidelines dealing with these issues. The guidelines include various consumer protections, such as disclosure (in the case of sales from bank premises) of the absence of coverage by deposit insurance or guarantee by the bank, interest and principal risks, potential conflicts of interest, and applicable deferred sales charges; restrictions on fund names, sales locations, and compensation practices; procedures for determining suitability of investments; and adequate training of sales personnel. The Policy Statement also includes provisions designed to ensure the independence of the Dreyfus funds and their boards and provides that transactions between the bank and its operating subsidiaries will comply with sections 23A and 23B of the Federal Reserve Act. The Policy Statement also sets out various limitations on credit and securities transactions between the bank holding company and the Dreyfus funds, and provides that Mellon will adopt adequate standards for statutory and regulatory compliance and management control.

If the transaction were to be approved, the OCC would take care to make its examiners fully aware of the voluntary commitments made by Mellon in its notice and direct them to review Mellon's compliance with the Policy Statement Mellon has committed to adopt. If our examiners found any failure to abide by the commitments, the OCC would take appropriate supervisory actions.

OCC conditions could also include compliance with any voluntary commitments made in the notice, if the OCC determined that inclusion was necessary to address concerns raised by the proposed transaction. Should a bank or operating subsidiary fail to comply with any conditions, the OCC could pursue a range of enforcement remedies comparable to those available for violations of law. The OCC could seek cease and desist orders requiring compliance with the conditions and corrective action, civil money penalties and removals from banking in appropriate cases. See 12 U.S.C. § 1818(b), (c), (d), (e) and (i)(2).

Due to increasing national bank involvement in mutual fund activities, the OCC is reviewing its examination and supervision procedures to strengthen its oversight and to ensure that these activities are conducted in a safe and sound manner. Because we recognize that bank operating subsidiaries involved in mutual fund activities are also regulated by the SEC, we are working closely with the SEC to coordinate our respective supervisory efforts to enhance their effectiveness.

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II. The letter asks us to explain the statutory basis for allowing national bank subsidiaries and to discuss how the acquisition of Dreyfus is "incidental" to banking. The letter also asks us to explain whether the "incidental" to banking standard applicable to operating subsidiaries differs from the "closely related" to banking standard applicable to bank holding company subsidiaries.

National banks have established operating subsidiaries for approximately 28 years under OCC regulations first issued in 1966. Since then, operating subsidiaries have been allowed to engage only in those activities that are part of or incidental to the business of banking. See 31 Fed. Reg. 11459 (1966) (codified at 12 C.F.R. § 7.10) (repealed); OCC Interpretive Ruling 7.7376 (repealed); 12 C.F.R. § 5.34.*

National banks have authority to establish operating subsidiaries based on the National Bank Act, which allows banks to exercise certain enumerated powers and "all such incidental powers as shall be necessary to carry on the business of banking." See 12 U.S.C. § 24(7). Section 24 gives banks broad authority to engage in the business of banking and to exercise powers reasonably necessary to conduct that business. See OCC Letter No. 494 (December 20, 1989), reprinted in [1989-1990 Transfer Binder] Fed. Banking L.Rep. (CCH) ¶ 83,083.

The incidental powers of national banks include, at a minimum, all powers that are "convenient and useful" to express powers. See Arnold Tours, Inc. v. Camp, 472 F.2d 427, 432 (1st Cir. 1972). Many courts and the OCC believe that incidental powers are broader and include activities similar to traditional banking functions. As the Ninth Circuit has held, the incidental powers standard "must be construed so as to permit new ways of

"The OCC will decide the Mellon/Dreyfus proposal under the current regulation. As your letter notes, the OCC is considering revising this regulation as part of its regulatory simplification project. The project involves reviewing all existing OCC regulations to determine whether they are still appropriate and effective. OCC staff are currently reviewing the operating subsidiary regulation, but we have made no final decisions about whether or how to revise it. Any proposed changes would be published for comment and any comments received would be fully considered by the OCC before any final decision is made.

"In defining "incidental" powers, the Supreme Court has considered whether the power at issue is a generally adopted method of banks or is similar or related to a common industry practice, whether the power promotes the convenience of the business of banking or is usual and useful given modern competition, and whether the power is generally reasonable and appropriate. See, e.g., Franklin National Bank v. New York, 347 U.S. 373, 377 (1954); Colorado National Bank v. Bedford, 310 U.S. 120, 140 (1913); Clement National Bank v. Vermont, 231 U.S. 120, 140 (1913); Wyman v. Wallace, 201 U.S. 230, 243 (1906); First National Bank v. National Exchange Bank, 92 U.S. 122, 127 (1876); Merchants' National Bank v. State Bank, 77 U.S. 604, 648 (1871).

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conducting the very old business of banking." M & M Leasing Corp v. Seattle First National Bank, 563 F.2d 1377, 1382 (9th Cir. 1977), cert. denied, 436 U.S. 956 (1978).

The establishment of operating subsidiaries that carry on the business of banking falls squarely within the incidental powers of banks under both the narrow and broader view. These subsidiaries are a "convenient and useful" means of conducting banking business. See 12 C.F.R. § 7.10(c)(2). Because establishment of operating subsidiaries is part of the business of banking, it is not proscribed by 12 U.S.C. § 24(7) provisions on purchasing corporate stock. See 12 C.F.R. § 7.10(b). We are reviewing the Mellon/Dreyfus notice to determine whether the activities proposed for the operating subsidiary are part of or incidental to the business of banking.

The "incidental powers" standard for national banks is distinct from the "closely related to banking" test of section 4(c)(8) of the Bank Holding Company Act. The latter test governs the scope of the non-banking activities that may be carried on by subsidiaries of bank holding companies and is subject to interpretation by the Federal Reserve Board. See 12 U.S.C. § 1843.

In interpreting the "closely related to banking" test, the Federal Reserve Board has applied standards similar to those that the OCC applies under the "incidental powers" standard. The Board has found an activity "closely related to banking" if banks generally conduct the activity, provide services that are so similar to the activity that they are well equipped to engage in the activity, or provide services so integrally related to the activity as to require provision of the activity. Indeed, the Board has relied on OCC "incidental powers" precedent when making decisions under the "closely related to banking" test. Using the "closely related to banking" test, the Board has permitted bank holding companies to engage in extensive mutual fund activities. See, e.g., Mellon Bank Corporation, 79 Fed. Res. Bull. 626 (1993); 12 C.F.R. Part 225.

III. The letter asks if the proposed acquisition should be subjected to more stringent scrutiny than provided for under OCC rules and suggests that the application be published for public comment.

OCC regulations require a national bank to notify the OCC before creating an operating subsidiary. The OCC may extend the 30-day review period when a bank's letter of notification raises issues that require additional information or analysis, and we have done so for the Mellon notice. OCC policy provides for careful scrutiny of novel or significant filings to determine if proposed activities are legally permissible for a national bank and to review proposals for consistency with safe and sound banking practices and consumer protections. Before an operating subsidiary may be established, the OCC may require changes in proposed activities, prohibit proposed activities, impose conditions designed to ensure safe and sound operations, or take other actions deemed appropriate. Under OCC policy, novel or significant filings, such as the Mellon proposal, receive a higher level of review within the Office than routine filings.

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