A series of recent changes to securities and commodities rules have implications for operators of and advisors to pooled investment vehicles, including vehicles that issue collateralized loan obligations (“CLOs”). This briefing is a summary of recent rule changes that may affect CLO managers and what such managers should consider to remain in compliance in light of these rule changes.
Changes to Definition of Swap Potentially Pull CLO Managers into CFTC Registration Regime
In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) provided that swaps will be regulated by the Commodity Futures Trading Commission (the “CFTC”) and amended the definitions of “commodity pool operator” (or “CPO”) and “commodity trading advisor” (or “CTA”) to specifically include transactions in swaps.
What are CPOs and CTAs?
Under the Commodity Exchange Act (the “CEA”), operators of investment vehicles that trade commodity interests, now including swaps, are considered CPOs and must either register as a CPO or be exempt from registration. Likewise, under the CEA, persons who, for compensation, engage in the business of advising others regarding the value of, or the advisability of trading any contract of sale of a commodity or a swap are deemed CTAs and must either register as a CTA or be exempt from registration.
Definition of Swap Adopted
Under the Dodd-Frank Act, Congress left it to the CFTC, the Securities and Exchange Commission (the “SEC”) and various other regulators to provide rules that further define the term “swap” as well as a number of other related terms (e.g., “security based swap” and “mixed swap”). In July, the SEC and the CFTC adopted final rules that the included the definition of the term “swap,” which includes interest rate swaps, currency swaps, rate floors and caps, foreign exchange swaps, credit default swaps, debit index swaps, foreign currency options, commodity options, cross currency swaps, forward rate agreements, options to enter into swaps, and swaps on two or more loans. The adoption of the final definition of swaps has initiated the process of determining whether investment managers that use swaps must register as a CPO and/or CTA.
Impact on CLO Managers
Under most indentures, CLOs are permitted to enter into interest rate or currency swaps as a way to hedge the CLO’s portfolio against fluctuations in interest or exchange rates. If a CLO is not currently a party to a swap transaction, despite its ability to do so, then the CLO manager is not required to register or find an exemption from registration with the CFTC, but will be required to register or find an exemption from registration prior to the CLO entering into any swaps transactions. Managers of CLOs that do engage in swap transactions must either provide a notice of exemption (by October 12, 2012) where notice is required by the applicable exemption, or register as CPOs or CTAs (by December 31, 2012).
Exemptions from CFTC Registration
Under the CEA, there are several possible exemptions for CPOs and CTAs to rely upon to avoid registration. Below is a brief summary of some, though not all, potentially available exemptions from CPO and CTA registration for CLO managers.
Exemption from Registration as a CPO
One exemption that CLO managers may rely on is Rule 4.13(a)(3) under the CEA. This rule provides an exemption from registration for an operator of a pool (in this case, the CLO) that meets the following requirements:
The pool (the CLO) limits its positions in commodity interests such that:
- the aggregate initial margin, premiums, and required minimum security deposit for retail forex transactions required to establish such positions, determined at the time the most recent position was established, will not exceed 5% of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into (provided that, in the case of an option that is in-the-money at the time of purchase, the in-the-money amount may be excluded in computing such 5%); or
- the aggregate net notional value of such positions, determined at the time the most recent position was established, does not exceed 100% of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into.
For example, if a CLO manager manages a CLO with a liquidation value of $400,000,000 (most likely the liquidation value will equal the net asset value) and has entered into an interest rate swap with a notional amount of $100,000,000, the CLO manager would satisfy the “notional test” set forth in Rule 4.13(a)(3) (per (ii) above) and would be exempt from registration as a CPO because the net notional value of the swap position is well below 100% of the liquidation value of the CLO.
The pool generally is required to meet either of the limits above at all times and, importantly, need only meet one of these tests.
Additionally, all of the pool’s investors must be accredited investors, family trusts formed by accredited investors, knowledgeable employees, or non-United States persons, which will be the case for most CLOs.
To claim an exemption from registration as a CPO under Rule 4.13(a)(3), a CLO manager must do the following (by October 12, 2012):
- Obtain access to and establish an account with the National Future Association’s (the “NFA”) online exemption filing system (the “exemptions system”).
- Through the exemptions system, provide the NFA notice of eligibility for the Rule 4.13(a)(3). CPOs should claim the exemption by selecting the appropriate option from a drop-down box in the exemptions system. For CLO managers managing CLOs that have not yet launched, this filing is due prior to delivering subscription documents to prospective investors;
- Provide a cautionary statement to investors that the CPO is exempt from registration and therefore is not required to comply with disclosure and reporting requirements for registered CPOs (which, in the case of an existing CLO, would likely be a notice by the CLO manager to the CLO trustee with a request that the trustee forward such notice to the investors); and
- Agree to provide certain books and records upon CFTC request.
Additionally, the exempt CPO must also either affirm on an annual basis the notice of exemption from registration or withdraw its exemption.
Exemption from Registration as a CTA
There are also exemptions from registration as a CTA. Rule 4.14(a)(5) provides that an advisor that is a CPO exempt from registration also is exempt from registration as a CTA with respect to that commodity pool. For example, a CLO manager exempt from registration as a CPO under 4.13(a)(3) is exempt from registering as a CTA with respect to that same CLO under 4.14(a) (5). This exemption is self-executing and eligible CTAs need not make any filings to claim such exemption. Most CLO managers should fall into this Rule 4.14(a)(5) self-executing exemption from CTA registration. In the event that a CLO manager is not exempt from registration as a CPO, other exemptions from registration as a CTA may be available.
Current Lobbying Efforts
Certain industry groups, including the American Securitization Forum (“ASF”), have been lobbying the CFTC to exempt securitization vehicle managers (including CLO managers) from registration with the CFTC. In August, ASF submitted a letter to the CFTC, requesting a formal exclusion of certain securitization vehicles from regulation as commodity pools. We will continue to keep our clients updated of developments in this area.