On June 25, 2013, the U.S. Court of Appeals for the D.C. Circuit held that the CFTC lawfully adopted amendments to a rule that will require many investment companies to be regulated as commodity pools. The challenge was brought by the Investment Company Institute and the U.S. Chamber of Commerce (Appellants), which claimed that the arbitrary and capricious actions of the CFTC in adopting amendments to CFTC Rule 4.5 in 2010 amounted to violations of the Administrative Procedures Act and the Commodity Exchange Act.

The 2010 amendments to CFTC Rule 4.5 require, among other things:

  • certified regular reports from commodity pool operators (CPOs); and
  • that, to be eligible for exclusion from the definition of a commodity pool:
    • an investment company’s nonbona fide hedging trading must be less than or equal to 5 percent of the liquidation value of the fund’s portfolio; or
    • the aggregate net notional value of the trading must be less than or equal to 100 percent of the liquidation value of the pool’s portfolio.

As amended, Rule 4.5 requires an investment company’s investment adviser, rather than the fund itself, to register as a CPO.

The Court of Appeals rejected each of the Appellants’ arguments, including, in particular, an argument that the CFTC failed to meet legal standards because it offered an inadequate evaluation of the rule’s costs and benefits. The Court said that, unlike other cases when it threw out SEC regulations for deficient costsbenefits analysis, the CFTC concluded that it, rather than the SEC, was in the best position to oversee funds engaged in “more than a limited amount of nonhedging derivatives trading.” Given the SEC’s lack of a “comprehensive and systematic approach” to derivativesrelated issues, the Court said, the CFTC could fill in the gaps in existing regulation.

The Court of Appeals’ decision is yet another striking example of how the pendulum has swung toward the side of more regulation, following a period of “hands off” regulation leading up to the financial crisis of 2008. The CFTC has yet to finalize the harmonization rules, which are sure to generate some controversy and lead to additional compliance costs.

Click here to read our alert about the Court of Appeals decision.