Title VII of the Dodd-Frank Wall Street Accountability and Consumer Protection Act (the Dodd-Frank Act) is called the “Wall Street Transparency and Accountability Act of 2010” and covers “swaps.” Title VII is intended to establish a comprehensive regulatory framework for over-the-counter derivatives to reduce risk, increase transparency, and promote market integrity within the financial system by, among other things (and in the words of the Commodity Futures Trading Commission (CFTC) and the Securities Exchange Commission (SEC)): “(i) Providing for the registration and comprehensive regulation of swap dealers and major swap participants; (ii) imposing clearing and trade execution requirements on standardized derivative products; (iii) creating rigorous recordkeeping and real-time reporting regimes; and (iv) enhancing the Commission’s rulemaking and enforcement authorities with respect to all registered entities and intermediaries subject to the Commission’s oversight.”1
Among the more significant amendments made by Title VII to the Commodity Exchange Act (CEA) are Section 721(a)(5), which added a definition of “commodity pool,” and Section 721(a)(6), which expanded the scope of the term “commodity pool operator” to include those that invest in non security-based swaps.
Through a series of orders, the CFTC has provided temporary exemptive relief from certain provisions of the CEA, including certain self-effectuating provisions that reference terms that require further definition. As the term “swap” required further definition, many entities have awaited the final definition to determine if they would fall within the definition of “commodity pool operator” and, thus, determine whether they would be required to register with the CFTC or could avail themselves of an exemption from registration. With the recent adoption2 by the CFTC of a final rule that defines a “swap,” and the related publication thereof in the Federal Register, 3 the amendments made by Section 721(a)(5) and (6) will become fully effective on or around October 12, 2012.
Notably, the CFTC has historically taken the view that a single swap or other commodity interest can constitute a commodity pool and that an “investment trust” need only have a single owner.4
Accordingly, unless exemptive or equivalent (see below) relief is available, a project company that has one or more swaps may be a commodity pool and the sponsor or other operator thereof may be a commodity pool operator or commodity trading advisor and thereby subject to registration with, and regulatory oversight by, the CFTC.
Certain persons who form and/or have administrative or other responsibilities in relation to commodity pools are “commodity pool operators” (CPOs) and, absent a relevant exemption with respect to each related commodity pool, they are required to register with the CFTC. Once registered, CPOs may be subject to compliance obligations, including filing certified annual reports and submitting their offering documents for pre-approval. Although most project companies would not have a person that clearly corresponds to the role of CPO under commodity pool law and regulation—including because the role encompasses the functions of a sponsor and of a person responsible for ongoing management— candidates for deemed CPO status could include sponsors and project operators.
Similar requirements apply to persons acting in an investment advisory or similar capacity with respect to a commodity pool, who are known as “commodity trading advisors” (CTAs). Although most project companies would not have any person designated as the CTA thereof, persons who potentially could be considered CTAs include sponsors, operators or other persons who have authority or discretion in connection with the company’s entry into or termination of swap transactions.
In general, CPOs and CTAs would be subject to increased duties and a heightened standard of care (relative to non-CPO/CTA sponsors of or advisors to a project company) and, thereby, a greater risk of potential related liability. Registration as a CPO or CTA also requires membership in the National Futures Association (NFA), and NFA members are subject to periodic examination and audit and generally are required to ensure that their “associated persons” satisfy certain proficiency examination requirements. Persons deemed to be acting as a CPO or CTA without being registered or exempt from registration as such would be in violation of the CEA and could be subject to potential felony conviction and substantial penalties.5
Although an exemption from registration as a CPO may be available under the CFTC's Rule 4.13(a)(3) in respect of some privately offered transactions that also satisfy one of two alternative de minimis trading tests (based on an objective calculation), there are technical aspects of the regulation that may limit its usefulness for many projects. In any event, while exemption from CPO registration (if and when available) reduces certain related operational and compliance burdens, the relevant entity is still a commodity pool, and its CPO and CTA are still subject to regulation under the CEA, including its anti-fraud provisions.
There is considerable uncertainty regarding the extra-territorial application of the commodity pool provisions to persons and transactions that are outside of the United States. In particular, it is not clear to what extent the CFTC’s recently proposed guidance6 on cross-border application of certain swap-related definitions and provisions (the “Cross-Border Proposal”) would apply to cross-border application of the “commodity pool operator” and “commodity trading advisor” definitions.
Although the Cross-Border Proposal specifically provides guidance regarding the CFTC’s extraterritorial jurisdiction with respect to the definitions of “swap dealer” and “major swap participant,” the Cross-Border Proposal does not directly contain the CFTC’s views regarding the extraterritorial application of its CPO or CTA rules. While some have suggested that the CFTC should apply its swap regulations narrowly in this context, the CFTC’s extra-territorial jurisdiction rests primarily on its longstanding statutory authority under CEA section 4m(1) (requiring registration for CPOs and CTAs who make use of the means and instrumentalities of US interstate commerce) and secondarily with respect to projects or the sponsors thereof whose swap activities “have a direct and significant connection with activities in, or effect on” US commerce (as provided for in CEA section 2(i)(1). It is by no means clear that the CFTC will limit its extra-territorial jurisdiction over commodity pools and their CPOs and CTAs.
Among the options being considered by other similarly affected entities and persons are the following:
- A rule that would provide permitted exemptions under the related definitional changes (although such a rulemaking could not be accomplished before the changes are/become effective and, in the past, the CFTC in granting exemptions has required7 that an applicant submit to the CFTC’s jurisdiction in order to claim an exemption therefrom);
- No-action relief from the CFTC (again it is unlikely that this relief could be obtained before the effectiveness of the definitional changes); or
- Clarification that would effectively exempt affected entities and related persons from this regulation in a CFTC-issued “frequently asked question” format (which might be obtained relatively quickly, but would probably not prevent the CFTC from changing any expressed view, with or without notice to affected persons).
While other similarly affected parties (for example, the securitization industry appears to be facing similar issues) are understood to be preparing to contact the CFTC and SEC regarding these requirements and their related consequences, and to possibly request exemptive relief, it is unclear what relief may be sought and, if relief is sought, the possible timing thereof is still unknown at this time.