If you are a private equity fund manager advising a fund that uses derivatives to hedge foreign exchange or interest rate risks, regulations of the U.S. Commodity Futures Trading Commission (CFTC) may require that you register as a “Commodity Pool Operator” (CPO) with the CFTC and subject yourself to various operational and regulatory requirements.2 Even a private equity fund manager that is registered as an investment adviser with the U.S. Securities and Exchange Commission (SEC) or qualifies as an “exempt reporting adviser” under the Investment Advisers Act of 1940, as amended, must analyze whether it is a CPO under the CFTC’s rules, as the CFTC and SEC are separate regulators with different mandates.3
Although CFTC rules were not historically of concern for private equity fund managers (private equity funds tradi- tionally invest in securities, which are regulated by the SEC, as opposed to commodity interests, which are regulated by the CFTC), Dodd-Frank greatly expanded the CFTC’s ability to regulate private equity fund managers by including interest rate and currency derivatives within the definition of “swaps,” which are now characterized as “commodity interests” that fall under the CFTC’s jurisdiction.4 Due to this jurisdictional ex- pansion, the CFTC has broad regulatory power over a variety of hedging instruments that private equity funds often use to hedge interest rate and currency risks, among other things.
To comply with CFTC rules, private equity fund managers need to analyze whether they must register as a CPO and, if so, whether they fit within one of the CFTC’s exemptions from registration. This article addresses these issues through a series of short questions and answers.
- We Manage a Private Equity Fund That Invests Only in Securities. How Could We Be Subject to CFTC Regulations?
Unlike hedge funds, private equity funds generally do not invest in the various assets that the CFTC historically con- sidered to be “commodity interests.” However, Dodd-Frank amended the statutory definition of the terms “commodity pool operator” and “commodity pool” to include entities that trade in “swaps,”5 which is why private equity fund managers need to review whether they must comply with CFTC regula- tions (see Question 4 below). For example, when establishing a private equity fund that will acquire portfolio companies, it may still be desirable to manage risk through swaps positions, such as currency and interest rate swaps. A private equity fund that enters into swaps to hedge its currency or interest rate exposure therefore may fall within the CFTC’s jurisdiction and its manager should determine whether an exemption from CPO registration is available (see Question 6 below).
- We Manage a Private Equity Fund That Has Very Limited Hedging Arrangements. Are We Still Subject to CFTC Regulations?
Possibly. Private equity fund managers are subject to CFTC reg- ulations if their fund is operated “for the purpose” of trading in CFTC regulated “commodity interests,” which in turn will render their fund a “commodity pool” under the CFTC’s juris- diction.6 Unfortunately, the phrase “for the purpose” is not defined; rather, the CFTC states that the determination is a fact-intensive inquiry that depends on the circumstances. The CFTC has suggested in commentary to one of its rules that a fund entering into even one swap contract could be enough to characterize the fund as a commodity pool, therefore pos- sibly requiring the fund’s manager to register as a CPO unless a registration exemption is available (see Question 6 below).7
- We Are a Non-U.S. Manager of a Non-U.S. Private Equity Fund. How Could We Be Subject to CFTC Regulations?
The CFTC has suggested that private equity fund manag- ers who advise a non-U.S. fund with only one U.S. inves- tor (defined broadly by the CFTC to include a U.S. resident or citizen, an entity formed or incorporated in the U.S., and a foreign entity with its principal place of business in the U.S., among other things) are subject to CFTC regulations if their fund is operated “for the purpose” of trading in CFTC regulated commodity interests (as discussed in Question 2 above).8 In addition, a non-U.S. fund that trades outside the U.S. could be at risk of CFTC enforcement action if its trades impact prices in the U.S.
- What Currency and Interest Rate Hedging Activities Are Regulated by the CFTC?
Dodd-Frank granted the CFTC broad jurisdiction over “swaps.” Swaps are broadly defined in the U.S. Commodity Exchange Act (CEA) and accompanying CFTC regulations to include: (i) interest rate swaps; (ii) currency swaps; (iii) foreign exchange swaps; (iv) total return swaps; and (v) credit default swaps.9 Subject to certain exclusions, a derivative will be a “swap” if it provides “one or more payments based on the value or level of one or more interest or other . . . financial or economic in- terests . . . based on the value thereof, and that transfers, as between the parties to the transaction, . . . the financial risk associated with a future change in any such value or level without also conveying a current or future direct or indirect ownership interest in an asset . . . or liability that incorporates the financial risk so transferred. . . .” 10 Given the breadth of this definition, it is generally a best practice to assume that a financial instrument that bears resemblance to a swap would be considered a “swap” under CFTC regulations.
- What Are the Penalties for Violating CFTC Rules?
The CEA provides a private right of action with respect to persons or entities that violate the CEA or willfully aid, abet, counsel, induce or procure the commission of a violation of the CEA. Among other things, the CFTC can also seek injunc- tions and administrative sanctions (including civil monetary penalties and revoking or restricting registration and ex- change trading privileges).
- What CPO Registration Exemptions Are Available?
U.S. and non-U.S. private equity fund managers may be able to claim an exemption from CPO registration if they only engage in a de minimis (i.e., minimal) amount of commod- ity interest trading activity pursuant to CFTC Rule 4.13(a)(3) and make the corresponding notice filing with the National Futures Association.11 This rule provides an exemption from CPO registration for the operators of commodity pools that are offered via private placement (i.e., without marketing to the public in the U.S.) generally only to “accredited investors” (or certain other categories of sophisticated investors) and satisfy the detailed numerical thresholds in the rule, which are summarized as follows:
At all times, the fund meets either of the following tests with respect to its commodity interest positions:
- The aggregate initial margin, premiums, and required minimum security deposit for retail forex transactions re- quired to establish such positions, determined at the time the most recent position was established, will not exceed 5% of the liquidation value of the fund, after taking into account unrealized profits and unrealized losses on any such positions it has entered into; or
- The aggregate net notional value of such positions, de- termined at the time the most recent position was es- tablished, does not exceed the liquidation value of the fund’s entire portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into.
Also, interests in the fund cannot be not marketed as or in a vehicle for trading in the commodity futures or commodity options markets.
To claim the CFTC Rule 4.13(a)(3) exemption, the CPO will need to file a notice of exemption with the NFA for each pool for which it claims an exemption (i.e., the exemption is not self-executing, and the notice of exemption must be reaf- firmed each year).
Additional exemptions from CPO registration exist, although in most circumstances they would not apply in the context of a private equity fund.
- Any Additional Considerations?
The CEA’s definition of “CPO” is broad and typically captures the general partner of a fund formed as a limited partnership, the managing member of a fund formed as a limited liabil- ity company and the directors of a fund formed as a corpo- ration.12 Although the CEA requires each person who comes within the CPO definition to register absent an available ex- emption, the CFTC has historically relieved non-exempt CPOs from registration if their pool’s investment manager served as its registered CPO in lieu of each general partner, managing member or director, subject to certain conditions. In May 2014 the CFTC announced that it has implemented a “streamlined approach” for a CPO to delegate its investment management authority over a commodity pool to a registered CPO (typi- cally the fund’s investment manager) if certain facts are met and a letter containing specific representations is sent to the CFTC requesting registration relief.13 CPOs that cannot make the required representations are able to seek separate no- action relief from CPO registration. Additionally, the CFTC’s streamlined approach for CPO delegation does not apply to CPOs that are exempt from CPO registration (whether under the 4.13(a)(3) de minimis exemption or otherwise).
In addition to CPO registration, general partners and invest- ment managers to commodity pools also need to assess their registration status as a commodity trading adviser (a CTA). A CTA is generally any person who, for compensation or profit, engages in the business of advising others as to the value (or the advisability) of trading in any contract of sale of a com- modity interest.
As a general matter, CTA registration is not a pressing concern for managers and general partners of traditional private equity funds, as CFTC Rule 4.14(a)(10) will exempt a general partner or manager from CTA registration so long as it has not furnished commodity trading advice to more than 15 persons during the course of the preceding 12 months and does not hold itself out generally to the public as a commod- ity trading adviser.14 Additionally, CFTC Rule 4.14(a)(5) exempts a firm from CTA registration if it is also exempt from CPO reg- istration and its commodity trading advice is directed solely to, and for the sole use of, the pool or pools for which it is so exempt.15
Even if a CPO is registered, it may be exempted from compli- ance with several CFTC rules if the applicable requirements of CFTC Rule 4.7 are met. CFTC Rule 4.7 provides in relevant part that the registered CPOs of pools owned exclusively by “quali- fied eligible persons” (which includes “qualified purchasers” (as defined in section 2(a)(51)(A) of the Investment Company Act of 1940, as amended) and non-United States persons (as defined in CFTC Rule 4.7)), among others, are relieved from certain disclosure, recordkeeping and reporting requirements if a notice filing is made with the NFA for each eligible pool.