The Commodity Futures Trading Commission's (CFTC) new “harmonization rules” adopted on August 13, 2013 in response to its amending CFTC Rule 4.5 in 2012 will not require commodity pool operators (CPOs) of investment companies registered under the Investment Company Act of 1940, as amended (Registered Funds), to overhaul their existing compliance programs regarding disclosure, reporting and recordkeeping. The CFTC's new harmonization rules will generally permit CPOs of Registered Funds to comply with applicable Registered Fund disclosure rules of the U.S. Securities and Exchange Commission (SEC) as a means of satisfying CFTC disclosure rules applicable to such CPOs. In connection with the CFTC's new harmonization rules, the SEC’s Division of Investment Management issued guidance regarding Registered Funds’ trading in and disclosure of derivatives, which largely echoes SEC staff guidance provided in 2010.
The CFTC adopted amendments to Rule 4.5 in February 2012 which require a Registered Fund to meet certain de minimis trading restrictions and other requirements in order for its investment adviser to be exempt from registering as a CPO, in contrast to the previous rule that exempted any investment adviser to a Registered Fund from CPO registration. A registered CPO typically must comply with CFTC rules regarding disclosure, reporting and recordkeeping of Part 4 under the Commodity Exchange Act (CEA) with respect to the pools it operates, including Registered Funds. As part of the amendments to Rule 4.5, the CFTC proposed rules to harmonize the CFTC disclosure, reporting and recordkeeping requirements applicable to CPOs to Registered Funds with the SEC disclosure, reporting and recordkeeping rules applicable to Registered Funds.
In adopting the harmonization rules, the CFTC recognized and sought to address the difficulties and the increased burden inherent for a CPO to a Registered Fund to comply with the CFTC regime and the SEC regime requirements regarding disclosure, reporting and recordkeeping. The proposed harmonization rules attempted to amend CFTC rules applicable to CPOs to Registered Funds to include various alternative mechanisms to enable those CPOs to comply with Part 4 under the CEA. After consideration of numerous comments, the CFTC changed course and will instead implement a substituted compliance approach permitting registered CPOs to Registered Funds to meet the compliance obligations under Part 4 by complying with the SEC’s rules for Registered Funds.
The SEC’s Division of Investment Management issued IM Guidance Update No. 2013-05, “Disclosure and Compliance Matters for Investment Company Registrants That Invest in Commodity Interests” (Guidance Update) simultaneous with the CFTC's adoption of the harmonization rules to assist those Registered Funds that invest in commodity interests in preparing disclosure filings and in their consideration of compliance issues related to derivation. The Guidance Update contains a helpful summary of the SEC staff’s historical views, discusses the SEC’s new Risk and Examinations office and that office’s role, and acknowledges the CFTC’s harmonization rules.
Key Takeaways from the Harmonization Rules and Guidance Update
- A CPO to a Registered Fund will be exempt from the requirements of Rules 4.21, 4.24, 4.25, and 4.26 under the CEA (the substantive rules with respect to disclosure, reporting and recordkeeping for the CPO to a commodity pool) provided that disclosure provided with respect to the Registered Fund complies with the provisions of the Investment Company Act of 1940, the Securities Act of 1933, the Securities Exchange Act of 1934, the regulations promulgated thereunder, and any guidance issued by the SEC or any of its divisions. In short, a Registered Fund must continue to comply with the laws typically applicable to it as an SEC registrant for its CPO to satisfy its own CFTC obligations.
- A CPO to a Registered Fund will be exempt from the account statement distribution requirements in Rules 4.22(a) and (b) under the CEA so long as the CPO makes the current net asset value per share available to investors and clearly discloses in the fund prospectus that the information will be readily accessible on the CPO’s website along with the internet address.
The following additional obligations, beyond those required of a Registered Fund by the SEC, are imposed on a CPO to a Registered Fund:
- The CPO must file notice of its use of the substituted compliance regime with National Futures Association (NFA) and, if using a third-party service provider for recordkeeping purposes, a notice of the CPO’s intent to use the service provider;
- The Registered Fund will not be required to include the typical CFTC cautionary statements on the cover page of its prospectus, so long as the Registered Fund includes in the cover page legend required by Rule 481 under the Securities Act of 1933, as amended, that the CFTC, in addition to the SEC, has not approved or disapproved of the securities or passed upon the accuracy or adequacy of the disclosure in the prospectus.
- The CPO is generally exempt from the CFTC’s performance disclosure requirements except with respect to Registered Funds with less than a three-year operating history, for which the CPO must disclose the performance of all accounts and commodity pools that are managed by its investment adviser that have investment objectives, policies, and strategies substantially similar to those of the Registered Fund; and
- The CPO will be required to file with the NFA the financial statements that it prepares pursuant to its obligations with respect to the SEC, but may file a notice requesting an extension to align the CFTC/NFA filing deadline with that of the SEC.
- If a Registered Fund uses a controlled foreign corporation, or CFC, to invest in commodity interests, the CFTC determined that, if the Registered Fund provides full disclosure of material information regarding the activities of its CFC through its obligations to the SEC and consolidates the financial statements of the CFC with those of the Registered Fund, the CFC will not be required to separately prepare a disclosure document or file financial statements with the NFA.
- Harmonization Rules Compliance Dates: The harmonization rules took effect on August 22, 2013. Registered CPOs seeking exemption under the harmonization rules are required to begin compliance for Registered Funds beginning when a Registered Fund files with the SEC an initial registration statement or, for an existing Registered Fund, its first post-effective amendment that is an annual update for an open-end fund or when the Registered Fund is required to update its registration statement for a closed-end fund. CPOs to larger Registered Funds required to file Form CPO-PQR must comply with Rule 4.27 under the CEA (the rule mandating the filing of the form) 60 days following the harmonization rules’ publication in the Federal Register.
The Guidance Update released by the SEC's Division of Investment Management recognized the CFTC’s harmonization rules and highlighted four major areas of concern for Registered Funds trading derivatives:
- Disclosure. Registered Funds are reminded to adequately disclose the risks associated with investments in derivatives. The staff requires Registered Funds that use or intend to use derivative instruments to assess, on an ongoing basis, the accuracy and completeness of the related disclosure. A Registered Fund should review whether the disclosure is presented using plain English, whether the disclosure is tailored to the types of derivatives used, the extent of the use of derivatives, and the purpose for using derivative transactions in light of the investment objective and strategy.
- Performance Presentations. The Guidance Update emphasizes that a Registered Fund is responsible for ensuring that performance information is not materially misleading. Specifically, the guidance notes that a Registered Fund should not exclude the performance of any other funds or private accounts that have substantially similar investment objectives, policies and strategies if the exclusion would cause the performance shown to be materially higher or more favorable than would be the case if the funds or accounts were included (i.e., “cherry picking”). As described above, a Registered Fund trading in derivatives that are commodity interests with less than a three-year operating history would be required under the harmonization rules to include the performance of similar accounts operated by the CPO.
- Legends. The staff will permit a Registered Fund that invests in derivatives that are commodity interests to include the modified legend described above on the cover page of its prospectus.
- Compliance. Registered Funds should adopt and maintain policies and procedures sufficient to monitor the accuracy of disclosures made about the Registered Fund’s use of derivatives and the associated risks, and the Registered Fund’s investments in derivatives to ensure consistency with stated investment objectives and strategies.
- The Guidance Update also noted that a Risk and Examinations Office has recently been created within the Division of Investment Management. The Office is responsible for analyzing and monitoring the risk management activities of investment advisers, Registered Funds, and the investment management industry, and will work closely with the Office of Compliance Inspections and Examinations to develop its industry understanding.
In a relative win for the Registered Fund industry, a substantial overhaul of compliance programs and additional disclosure obligations expected by some investment advisers to Registered Funds will not be necessary. Commenters to the proposed harmonization rule appear to have convinced the CFTC that its attempt to merge its commodity pool disclosure rules with the substantial (and largely similar) requirements already imposed on Registered Funds by the SEC would result in costly compliance burdens with little apparent increase in shareholder protections. Registered Funds that rely on a significant use of swaps or other commodity interests will nevertheless bear additional costs associated with CPO registration in light of amended Rule 4.5. The cost of compliance for the new oversight by the CFTC, however, is not expected to be overly burdensome for Registered Funds and their advisers.