This memorandum supplements our recent memorandum on this subject dated February 10, 2012.
The Commodity Futures Trading Commission (the “Commission” or “CFTC”) has adopted significant amendments to the Part 4 rules, which govern the operations and activities of commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”) under the Commodity Exchange Act (the “CEA”).1 Among other things, these amendments (1) eliminate the exemption from CPO registration in Rule 4.13(a)(4); (2) eliminate the ability of a registered CPO operating a pool pursuant to Rule 4.7 to claim relief from the certification requirement for financial statements contained in commodity pool annual reports; (3) require the annual filing of notices by CPOs and CTAs claiming relief under various provisions of the Part 4 rules; (4) modify the criteria for claiming relief from CPO registration for investment companies registered with the Securities and Exchange Commission (the “SEC”) under the Investment Company Act of 1940 (the “ICA”) pursuant to Rule 4.5, the Commission’s “not a pool” rule; (5) include new risk disclosure requirements for CPOs and CTAs regarding swap transactions; and (6) require reporting by registered CPOs and CTAs with respect to their direction of commodity pool assets similar to the SEC’s Form PF, with streamlined and simplified reporting for CPOs and CTAs who are also registered investment advisers under the Investment Advisers Act of 1940 (the “Advisers Act”) and who file Form PF with the SEC. Notably, the Commission was persuaded by commenters to retain the exemption from CPO registration in Rule 4.13(a)(3) for privately offered funds which engage in a limited or “de minimis” amount of commodity interest trading.
In addition, the Commission issued a proposed rule for public comment which seeks to harmonize CFTC and SEC disclosure, reporting, and recordkeeping requirements for registered investment advisers who would be required to register as CPOs under the amendments to Rule 4.5 in respect of certain registered investment companies (“RICs”).2 Comments are due on the Harmonization Rules by April 24, 2012.
The effective date of the new rules generally will be April 24, 2012 (the “Effective Date”), but certain provisions have subsequent effective dates. Also, the rules contain a complicated set of compliance dates for various provisions. For example, CPOs currently relying on Rule 4.13(a)(4) with respect to any pool may continue to do so until December 31, 2012.
The Commission explained its decision to reexamine the appropriate level of regulation for entities participating in the futures and derivatives markets in light of the financial crisis during 2007 and 2008 and the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).3
However, there is no evidence that inadequate regulation of fund managers contributed to the recent financial crisis and the Dodd-Frank Act does not direct the Commission to reexamine or modify the scope of the existing exclusions and exemptions for CPOs. Rather, this rulemaking can be more appropriately viewed as yet one more manifestation of the current regulatory environment.
In particular, the elimination of Rule 4.13(a)(4), together with the inclusion of swaps in the commodity pool and CPO definitions pursuant to the Dodd-Frank Act and conforming rule amendments, will require some previously unregistered fund managers to register as CPOs (e.g., for a fund which enters into interest rate swaps, but not futures), comply with the Commission’s Part 4 rules, which include disclosure, reporting and recordkeeping requirements, and join the National Futures Association (“NFA”), the designated industry self-regulatory organization for CPOs and CTAs, unless they are able to rely on the exemption in Rule 4.13(a)(3) with respect to their funds. Such managers also may be able to claim relief under Rule 4.7, which provides an exemption for registered CPOs from most, but not all, of the requirements that would otherwise be applicable to them under the Part 4 rules.
In view of these developments, fund managers should review all their current funds, including domestic and offshore hedge funds, private equity funds, real estate funds and fund of funds, for which the CPO relies or intends to rely on Rule 4.13(a)(4) to assess whether the CPO will be eligible to rely on Rule 4.13(a)(3) or Rule 4.7 in the future, or whether a fund may no longer be a commodity pool in which case reliance on these exemptions is not necessary. If a fund is offered and sold exclusively to non-U.S. persons, it may be possible to rely on CFTC Advisory 18-96. See discussion infra p.4. Once such a review is complete, a number of follow up action items will need to be implemented, including as appropriate, notice to fund investors of changes in exemptions prior to year end, initiating the process for registration as a CPO, withdrawal of existing exemption notices and filing of new exemption notices with NFA, and updating fund offering documents to reflect these changes.
The following sections of this memorandum address the most significant features of the new Part 4 rules.
Rescission of Rule 4.13(a)(4)
Despite arguments from many commenters, the Commission rescinded the exemption from CPO registration in Rule 4.13(a)(4), which has been widely relied on by fund managers since 2003 in connection with private fund offerings to sophisticated investors such as “qualified purchasers” under Section 2(a)(51)(A) of the ICA, knowledgeable employees as defined in Rule 3c-5 under the ICA, and non-United States persons. The Commission concluded that eliminating this exemption is justified because pools operating under Rule 4.13(a)(4) can potentially engage in an unlimited amount of commodity interest trading which therefore warrants CFTC regulation to ensure adequate customer protection and market oversight.
With respect to the timing of implementation of the rescission of Rule 4.13(a)(4), CPOs currently relying on Rule 4.13(a)(4) with respect to any pool may continue to do so until December 31, 2012. We believe that CPOs also may claim relief under Rule 4.13(a)(4) with respect to any other pool which commences its operations by the Effective Date and may continue to rely on such exemption until December 31, 2012.
Retention of Rule 4.13(a)(3)
As noted, the Commission was persuaded by commenters including NFA to retain Rule 4.13(a)(3), which provides an exemption from CPO registration for the operator of a private pool which is offered and sold to certain specific categories of investors and that engages in limited commodity interest trading activities. A CPO is not required to register under Rule 4.13(a)(3) provided that: (i) interests in the pool are exempt from registration under the Securities Act of 1933 (the “Securities Act”); (ii) interests in the pool are offered and sold in the United States without marketing to the public; (iii) participation in the pool is limited to: (a) “accredited investors” as defined in Rule 501 under the Securities Act, (b) family trusts formed by accredited investors, (c) “knowledgeable employees” as defined in Rule 3c-5 under the ICA, (d) the CPO itself, and (e) certain other qualified eligible persons such as non-United States persons as defined in Rule 4.7; (iv) the CPO limits the commodity interest positions (including soon, swaps) in the pool at all times such that either: (a) the aggregate initial margin and premiums required to establish such positions do not exceed 5% of the liquidation value of the pool’s portfolio or (b) the aggregate net notional value of such positions does not exceed 100% of the liquidation value of the pool’s portfolio; and (v) the CPO does not market the pool to the public as or through a vehicle for trading in the commodities markets. To rely on this exemption, the CPO must file a notice of claim for relief with NFA.
The Commission declined to increase the current trading threshold under Rule 4.13(a)(3), even though the inclusion of “swaps” will make it more difficult to satisfy the trading threshold in the future.4 The Commission reasoned that it would be premature to increase the threshold at this time and that it may be more appropriate to increase the trading threshold at a later time after having collected systemic risk data from registered CPOs through Form CPO-PQR.
The Commission amended Rule 4.13(a)(3)(ii)(B) to provide some guidance as to the net notional value of cleared swap positions and the ability to net swaps cleared by the same derivatives clearing organization. However, it is likely that questions will arise about how to apply the trading limits in Rule 4.13(a)(3) to swaps. The Commission also had previously issued guidance on the availability of the trading limits in Rules 4.13(a)(3) in the fund of funds context, but this guidance was included in an Appendix A to the Part 4 rules and appears to have been removed from the final rules with no explanation.5 The Commission has not formally indicated whether it will replace Appendix A in the future to provide funds of funds with guidance on how to comply with Rule 4.13(a)(3). We believe that a CPO of a fund of funds who is currently relying on Rule 4.13(a)(3) or who may seek to rely upon Rule 4.13(a)(3) on the basis of the guidance in existing Appendix A may do so, pending subsequent guidance from the Commission or its staff.
Amendments to Rule 4.7
As noted, pursuant to Rule 4.7, a registered CPO who is able to claim relief for a private fund which is offered exclusively to certain “highly accredited” investors (“qualified eligible persons” or “QEPs”) is exempted from most, though not all of, the requirements of the Part 4 rules, including relief from the disclosure, reporting and recordkeeping requirements thereunder.6 QEPs include “qualified purchasers”, knowledgeable employees, non-United States persons as defined in Rule 4.7, and accredited investors who satisfy a $2 million portfolio requirement. For example, a registered CPO relying on Rule 4.7 with respect to a fund is exempt from filing with NFA, or delivering to prospective investors, a disclosure document for the pool that is compliant with CFTC requirements, subject to certain terms and conditions. In this regard, the eligible CPO must legend any offering memorandum used and keep certain specified books and records, including records sufficient to generate the annual and periodic reports (i.e., quarterly statements) required by Rule 4.7. The CPO of a “qualifying pool” is required to file a notice of claim for relief with NFA.
The Commission amended Rule 4.7 in only two respects. First, the Commission has eliminated the ability of a registered CPO relying on Rule 4.7 to claim relief from the certification requirement for financial statements contained in commodity pool annual reports. According to the Commission, this flexibility was seldom used by CPOs of Rule 4.7 funds and the exception from the certification requirement is no longer consistent with regulatory interests. Second, the Commission has incorporated by reference the “accredited investor” standard from the SEC’s Regulation D under the Securities Act rather than directly including its terms to avoid having to amend Rule 4.7 if the accredited investor definition is modified by the SEC.
CFTC Advisory 18-96
In addition to Rule 4.7, CFTC Advisory 18-96 permits a registered CPO to claim exemption from otherwise applicable disclosure, reporting and recordkeeping requirements with respect to pools offered only to non-U.S. persons. Although broader than the relief under Rule 4.7 in some respects, the relief under this Advisory is not available if the CPO solicits any U.S. persons.
Annual Notices for Continued Exemptive or Exclusionary Relief
The Commission adopted its proposal to require annual reaffirmance of a claim for exemption or exclusion under various provisions of the Part 4 rules.7 However, the Commission moved the due date for the annual notice requirement to the calendar year end for all filers. Thus, the annual notice will need to be filed on a calendar year end basis rather than the anniversary of the original filing as proposed. In this regard, the preamble states that a CPO or CTA will have 60 days from the calendar year end to affirm its exemption or exclusion, but it will be necessary for the Commission to reflect this new date in the final rules in a subsequent technical corrections notice.8
Failure to comply with the annual affirmation requirement will be treated as a request to withdraw the exclusion or exemption. Given NFA Bylaw 1101, which prohibits NFA members from doing business with non-members who are required to register with the CFTC but who are not, absent a valid exclusion or exemption from registration, the ramifications of withdrawal of such a notice become very significant not only for the particular entity, but for all NFA members. For this reason NFA members typically implement procedures which are designed to prevent violations of Bylaw 1101. Thus, futures prime brokerage account documentation and fund subscription agreements typically request representations regarding a prospective customer’s or investor’s registration status and ability to rely on an exclusion or exemption from registration.
Fund of Funds Exemption
The Commission confirmed its position that a fund of funds is itself a commodity pool for purposes of the CEA and CFTC rules, even if the fund of funds does not directly engage in trading commodity interests. The Commission declined to adopt any additional exemption for funds of funds at this time, due to a lack of data regarding their investment activities. The Commission stated that it might consider such an exemption after receiving data regarding fund of funds through systemic risk reporting.
Foreign Advisor Exemption
The Commission also declined to provide an exemption from CPO registration for non-U.S. based CPOs operating a pool with even one U.S. investor. Thus, if Rule 4.13(a)(3) is unavailable, a non-U.S. based CPO may need to register as a CPO and comply with CFTC requirements in such a circumstance. The CFTC concluded that it has insufficient information regarding such firms and that it would be preferable to withhold consideration of a foreign advisor exemption until it has received systemic risk data on such firms.
Family Offices Exemption
Despite numerous comments requesting the inclusion of an exemption from registration for family offices analogous to the exemption adopted by the SEC pursuant to the Dodd-Frank Act,9 the Commission declined to adopt a family offices exemption at this time. In this regard, the Commission noted its lack of information regarding the activities of such entities and also that Rule 4.13(a)(3) remains available to family offices. In addition, family offices may rely on staff “not a pool” interpretative letters already issued where permissible, and may continue to request interpretative relief on a case-by-case basis. Finally, the Commission is instructing the staff to examine the possibility of adopting a family offices exemption in the future.
Amendments to Trading Criteria under Rule 4.5
Rule 4.5 currently provides an exclusion from the definition of CPO for operators of certain otherwise regulated collective investment vehicles, including RICs, insurance company separate accounts, bank collective trust funds and employee benefit plan trusts, without regard to the extent of derivatives trading activities engaged by such entities. However, the Commission noted that “entities operating collective investment vehicles that engage in more than a de minimis amount of derivatives trading should be required to register with the Commission.”10 The Commission believes that entities offering products substantially identical to those of a registered CPO should be subject to substantially identical regulatory obligations. The Commission concluded that some RICs have been offering managed futures strategies, without making appropriate disclosures to the Commission or to investors in accordance with the Part 4 rules. The Commission therefore narrowed the scope of the exclusion from the CPO definition under Rule 4.5 for RICs, but not for the other categories of entities eligible for relief under Rule 4.5.
By way of background, prior to certain amendments to Rule 4.5 that the Commission made in 2003, an entity seeking relief under Rule 4.5 was required to make representations that the use of commodity futures and options for non-bona fide hedging purposes would be limited to 5% of the liquidation value of such entity’s portfolio and that it would not market the vehicle as a commodity pool to the public. The amendments adopted in 2003 eliminated these requirements, but the Commission has now reinstated them with respect to RICs in response to an NFA petition for rulemaking, with some new additions and modifications.11
As noted above, these amendments will require a RIC to represent that initial margin and premium for its commodity interest trading (including soon, swaps) will not exceed 5% of the liquidation value of the vehicle’s portfolio. The Commission agreed that positions which constitute “bona fide hedging” under Rule 1.3(z) or Rule 151.5 should not be included in the trading threshold, but the threshold includes financial futures contracts, security futures products, e.g., single stock futures contracts, and also risk management transactions involving these instruments, which may not constitute bona fide hedging. For this purpose, no distinction is made between actively or passively managed portfolios such as RICs which are index funds.
In response to comments, the Commission added an alternative test that may be used to satisfy the trading threshold, referred to as the “alternative net notional” test, which is based on the test in Rule 4.13(a)(3)(ii)(B), as described above. A RIC will be able to claim relief under Rule 4.5 if the aggregate net notional value of the RIC’s commodity interest positions, including futures, options and soon swaps, does not exceed 100% of the liquidation value of such entity’s portfolio. As noted, in contrast to the test in Rule 4.13(a)(3)(ii)(B), Rule 4.5 does not limit the use of futures, options, or swaps for bona fide hedging purposes.
Marketing Restriction for RICs Exempt from Registration under Rule 4.5
The proposed amendments to Rule 4.5 would have prohibited the marketing of interests in a RIC “as or in a vehicle for trading in (or otherwise seeking investment exposure to) the commodity futures, commodity options, or swaps markets”. However, the Commission decided to drop the clause “or otherwise seeking exposure to”, agreeing with commenters that this clause introduced uncertainty to the marketing restriction. The Commission will determine whether a RIC is in violation of the marketing restriction on a case-by-case basis, with the following non-exclusive factors being indicative of whether a RIC is marketed as a vehicle for trading in commodity futures, options, or swaps:
- The name of the fund;
- Whether the fund’s primary investment objective is tied to a commodity index;
- Whether the fund makes use of a controlled foreign corporation for its derivatives trading;
- Whether the fund’s marketing materials, including its prospectus or disclosure document, refer to benefits of the use of derivatives in a portfolio or make comparisons to a derivatives index;
- Whether, during the course of its normal trading activities, the fund or entity on its behalf has a net short speculative exposure to any commodity through a direct or indirect investment in other derivatives;
- Whether the futures/options/swaps transactions engaged in by the fund or on behalf of the fund will directly be its primary source of potential gains and losses; and
- Whether the fund is explicitly offering a managed futures strategy.
The Commission noted that it will give the final factor on the above list additional weight, but that no single factor will be dispositive. It is also worth noting that the marketing restriction is applicable to RICs, regardless of which test is used to satisfy the trading threshold.
Entity Required to Register as the CPO for RICs under Rule 4.5 Exclusion
In response to comments that requiring a member or members of a RIC’s board of directors to register as a CPO would “raise operational concerns for the registered investment company”, the Commission concluded that the investment adviser for the RIC is the most logical entity to serve as the RIC’s CPO in the event that a RIC will no longer qualify for exclusion under Rule 4.5, as amended.
Rule 4.5 Compliance Dates
Compliance with Rule 4.5 for the purpose of registration only will occur on the later of either December 31, 2012 or within 60 days following the adoption of final rules defining the term “swap” and establishing margin requirements for such instruments. Notwithstanding the preceding sentence, those entities that must register only due to the amendments to Rule 4.5 will be required to comply with the remainder of the Part 4 rules only after 60 days following the effectiveness of the Harmonization Rules.
The Commission proposed the Harmonization Rules to amend various Part 4 rules to “harmonize” compliance obligations for registered investment advisers to investment companies who are required to register as CPOs due to the changes to Rule 4.5 with their current compliance obligations under the securities laws. The Harmonization Rules are intended to prevent such dually registered firms from being subject to duplicative, inconsistent and potentially conflicting disclosure, reporting and recordkeeping requirements under the two regulatory regimes.
To obviate these concerns, the Commission proposed to amend Rule 4.12(c) to offer relief from the disclosure document delivery and acknowledgment requirements under Rule 4.21, certain periodic financial reporting obligations under Rule 4.22 and the requirement that records be maintained at the CPO’s main office under Rule 4.23. The proposed relief is similar to relief which the Commission recently adopted for exchange-traded funds.12 The Commission also proposed, where applicable, to require that registered CPOs and CTAs file updates of all disclosure documents 12 months from the date of the document rather than 9 months. The Commission is seeking comment on a number of issues, including whether any provisions of the Part 4 rules other than the provisions identified in the Harmonization Rules need to be addressed.
Risk Disclosure Statement for Swaps
The Commission also amended the generic risk disclosure statements in the disclosure documents required to be furnished by registered CPOs and CTAs to prospective investors to include the risks associated with their use of swaps. These new risk disclosures will be required for all new disclosure documents and all updates filed after the Effective Date. Of course, a CPO or CTA who is exempt from registration or who may rely on Rule 4.7 is exempt from this requirement.
Reporting Requirements and Changes to Forms CPO-PQR and CTA-PR
The Commission adopted certain provisions under Rule 4.27, which will require CPOs and CTAs that are registered with the Commission to file reports regarding their direction of commodity pool assets with NFA. The Commission attempted to limit the reporting burden on dually registered entities in some respects, including permitting CPOs that are dually registered with the SEC as investment advisers and that file Form PF only to file Schedule A of Form CPO-PQR, as opposed to also filing Schedules B and C. However, all registered CTAs, even if dually registered as investment advisers, will be required to file Form CTA-PR. In addition, while the Commission expressed its intent in the preamble to the final rules not to impose burdensome requirements on large dual registrants and to harmonize its systemic data collection requirements with SEC requirements, the instructions for completing Forms CPO-PQR and CTA-PR are not consistent with that intent in a number of respects.
The new CPO reporting requirements under Rule 4.27 become effective on July 2, 2012. The reporting dates are as follows:
- 60 days after the end of the CPO’s first calendar quarter ending after December 14, 2012 for CPOs having at least $1.5 billion in gross pool assets under management (requiring CPOs to aggregate certain pool structures); however, CPOs with gross pool assets under management in excess of $5 billion, which are apparently considered high priority filers, will initially be required to report 60 days after the end of the CPO’s first calendar quarter ending after July 2, 2012;
- 90 days after the end of calendar year 2012 for all other CPOs.
These reports must include a description of certain information, including, but not limited to, the amount of assets under management, use of leverage, counterparty credit risk exposure, and trading and investment positions for each pool. CPOs with more than $1.5 billion in gross pool assets under management must report certain information on an aggregate basis and on an individual level for pools operated by the CPO with a net asset value of $500 million or more.
Form CTA-PR requires basic information about the CTA and the pools under its advisement and it will need to be filed on an annual basis within 45 days after the end of a fiscal year.