On February 9, 2012, the Commodity Futures Trading Commission announced the adoption of final amendments to CFTC Rule 4.5 and other CFTC rules regarding registration and compliance obligations for commodity pool operators and commodity trading advisors. Prior to the amendments, registered investment companies were able to claim an exclusion from the definition of commodity pool operator and did not have to register with the CFTC as a commodity pool operator. As amended, the Rule 4.5 exclusion can be claimed by a fund only if it meets certain trading thresholds and complies with certain marketing restrictions. With respect to the trading thresholds, a fund must meet one of the following limits:
- The fund must limit its trading such that aggregate initial margin and premiums required to establish commodity futures, options on futures, or commodity swap positions do not exceed 5% of the liquidation value of the fund’s portfolio, after taking into account unrealized profits and losses (“percentage-of-margin test”). The percentage-of-margin test does not apply to transactions entered into for “bona fide hedging purposes” and allows funds to exclude from the calculation any portion of an option that is in-the-money at the time the option is purchased.
- The fund’s aggregate net notional value of its commodities-related trading positions not used for bona fide hedging purposes, determined at the time its most recent position was established, must not exceed 100% of the liquidation value of the fund’s portfolio, after taking into account unrealized profits and losses (“net notional test”). The term notional value is defined by asset class (e.g., with different definitions applying to futures and swaps) and the ability to net positions is also defined by asset class. For example, a fund may net futures contracts with the same underlying commodity across designated contract markets and foreign boards of trade, but swaps may be netted only if cleared by the same designated clearing organization.
With respect to marketing restrictions, amended Rule 4.5 prohibits a fund from marketing itself “as a vehicle for trading in the commodity futures, commodity options, or swaps markets.” In the adopting release, the CFTC provided the following list of non-exclusive factors relevant to making a determination of whether or not a fund is marketed as a vehicle for investing in commodity futures, commodity 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 the 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 acting 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 or indirectly be its primary source of potential gains and losses, and
- Whether the fund is explicitly offering a managed futures strategy.
The CFTC noted that it would give more weight to the final factor in the list, but that a fund that does not expressly hold itself out as a managed futures fund could nevertheless be viewed as violating the marketing restrictions if other indicia of a managed futures strategy are present. The CFTC also noted that merely disclosing that a fund may engage in derivative transactions incidental to its main strategy would not violate the marketing restrictions.
In the adopting release, the CFTC clarified that, if a fund cannot claim exclusion from the definition of commodity pool operator, the investment adviser to the fund is the entity required to register as a commodity pool operator. Investment advisers required to register as commodity pool operators as a result of the amendments to Rule 4.5 must register by the later of December 31, 2012 or 60 days after the effective date of the final rulemaking by the CFTC defining the term “swap,” which will be covered under amended Rule 4.5.
Concurrently with the adoption of amended Rule 4.5, the CFTC also proposed rule amendments to harmonize the CFTC’s disclosure, reporting and recordkeeping requirements with those of the SEC with respect to funds that will be subject to oversight by both the SEC and CFTC. Comments on the CFTC’s proposed harmonization rules are due by April 24, 2012.