On June 25, 2013, the U.S. Court of Appeals for the District of Columbia affirmed the decision of a district court to dismiss the joint suit filed against the Commodity Futures Trading Commission (the “CFTC”) by the Investment Company Institute and the U.S. Chamber of Commerce (collectively, the “plaintiffs”). The plaintiffs challenged the amendments to CFTC Rule 4.5 that significantly restrict the scope of the exclusion from commodity pool operator (“CPO”) registration for investment companies registered under the Investment Company Act of 1940. Adopted by the CFTC in February 2012, the amendments effectively reinstated the conditions for meeting the CFTC Rule 4.5 exclusion that had been in effect prior to August 2003, including trading and marketing limits, with certain modifications that are discussed in the February 23, 2012 Davis Polk Client Memorandum, CFTC Adopts Amendments to Registration Exemptions for CPOs and CTAs and Proposes Harmonization Rules for Registered Fund CPOs. For further discussions of the plaintiffs' original complaint and the decision of the district court, please see the April 19, 2012 Investment Management Regulatory Update and the January 22, 2013 Investment Management Regulatory Update, respectively.
According to the Court of Appeals’s opinion, the plaintiffs contended that the CFTC violated the Administrative Procedure Act in promulgating the amendments because the CFTC (i) failed to address its 2003 rationales for broadening CPO exemptions, (ii) failed to comply with the Commodity Exchange Act and failed to adequately evaluate the rule's costs and benefits, (iii) implemented rules that were arbitrary and capricious (the plaintiffs cited the CFTC’s inclusion of “swaps” in the trading threshold, the CFTC’s restrictive definition of bona fide hedging and the CFTC’s alleged failure to justify the 5% registration threshold) and (iv) did not provide for an adequate notice and comment period.
In rejecting the plaintiff’s claims, the Court of Appeals stated that an agency is not required to address previous rationales when, in a new rulemaking, the agency “changes course” and therefore the CFTC was not required to consider its rationales for broadening CPO exemptions in 2003. With respect to the plaintiffs’ cost-benefit argument, the Court of Appeals drew a distinction between this case and two recent cases in which the Court of Appeals had vacated SEC rules because the SEC “failed to address existing regulatory requirements to determine whether sufficient protections were already present.” The Court of Appeals agreed with the district court in holding that, unlike the SEC in the prior two cases cited by the plaintiffs, “the CFTC did consider whether [registered investment companies] were otherwise regulated, and concluded that CFTC regulation was necessary” nonetheless. In addition, the court upheld the CFTC's multi-step rulemaking process under which rules will need to be later harmonized with SEC rules. The Court of Appeals noted, however, that although a costs-benefit challenge with respect to harmonization is premature (since, according to the Court of Appeals, it would be “impossible to calculate the costs of an unknown regulation”), the plaintiffs may challenge the costs and benefits of the harmonization rulemaking once such rules are finalized.
The Court of Appeals also rejected the plaintiffs’ contention that the particulars of the amendments were arbitrary and capricious. In its opinion the Court of Appeals explained (1) that the Dodd-Frank Wall Street Reform and Consumer Protection Act was amended to include “swaps” in the definitions of CPO and commodity pool (therefore, according to the Court of Appeals, evidencing the importance of swaps), (2) that the plaintiffs’ argument regarding the definition of bona fide hedging was “nothing more than [a] policy disagreement with CFTC” and (3) that, under the arbitrary and capricious standard of review, an agency such as the CFTC is entitled to deference with respect to expert determinations such as the 5% threshold. Finally, the Court of Appeals held that the CFTC “gave adequate notice of CFTC’s approach to the cost-benefit analysis by setting forth the factors that CFTC would consider and summarizing expected costs and benefits.”