Under new Commodity Futures Trading Commission (CFTC) rules effective October 12th of this year, if an investment trust or similar entity is viewed as “trading” in swaps, its sponsor and other responsible parties may be required to register with the CFTC as “commodity pool operators” (CPOs) or may be required to register as “commodity trading advisors” (CTAs). There is a concern that holding even one swap will be treated as “trading.” Accordingly, for any securitization vehicle that holds a swap, either:
- The sponsor must conclude that holding a swap does not constitute trading in swaps or the vehicle is otherwise not a commodity pool, or, for a securitization sold pursuant to an exemption from SEC registration, that it qualifies for the CFTC’s sole remaining private offering exemption, which exempts commodity pools that hold limited commodities, or
- One or more parties engaged in sponsorship and management of the vehicle will be required to register as CPOs, or may be required to register as CTAs.
To the extent the sponsor is a banking entity and the vehicle is regarded as a commodity pool (even if an exemption from registration is available or the CFTC grants relief from registration), the vehicle will also likely be a “covered fund” under the proposed Volcker Rule regulations, and therefore subject to the restrictions of those regulations.
Industry participants are appealing to the CFTC for clarification, but it is unclear whether the CFTC will act before the October 12th effective date.
Pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), swaps (other than security-based swaps) were brought within the jurisdiction of the CFTC by inserting or amending several provisions of the Commodity Exchange Act (CEA).1 The new provisions are broadly worded, and raise concerns that investment trusts or other special purpose vehicles that act as ordinary end-users of swaps, including securitization vehicles that hold only one swap, may subject the sponsors or other parties involved in the organization and operation of such vehicles to registration with the CFTC as CPOs or CTAs.
The new requirements become effective on October 12th of this year, 60 days after publication in the Federal Register of a new joint rule (Swap Definition Rule) of the CFTC and the Securities and Exchange Commission (SEC),2 which, among other things, further defines the swaps that are subject to the new provisions. Absent some other form of exemption, even parties that operate existing securitization vehicles will have to register.3
Summary of the Relevant Provisions
The CEA prohibits a CPO or CTA from engaging in its business without registration with the CFTC. A CTA need not register if it has advised no more than fifteen persons over the preceding 12 months and does not hold itself out generally as a commodity advisor. A CPO, however, has no such exception, and becomes subject to the registration requirement with a single commodity pool.4
The definition of “commodity pool” in the CEA was added by the Dodd-Frank Act and includes “any investment trust, syndicate, or similar form of enterprise operated for the purpose of trading in commodity interests, including any … swap.” The definition of “commodity pool operator” was modified in a similarly broad fashion, to include any person “engaged in a business that is of the nature of a commodity pool … for the purpose of trading in commodity interests, including any … swap.” Note that the definitions capture only investment trusts or similar enterprises, and therefore do not capture a typical corporate end-user, but could capture a securitization vehicle. The keys to the interpretation of these definitions, however, are the word “trading” and the general nature and activities of commodity pools.
- Should an entity that merely invests in commodity interests for hedging purposes, rather than buying and selling them, be regarded as “trading” in such interests?
- Should an entity formed for the purpose of investment in assets other than commodity interests, and which pays most investors a debt-like principal amount and accrued interest, rather than a share of profit, be regarded as a commodity pool because an ancillary part of its strategy includes investing in a swap for hedging purposes?
Nothing in the previous rule-makings, interpretations or no-action letters of the CFTC would appear to preclude a finding that holding a single swap could constitute “trading,” and, in fact, the CFTC has indicated to industry participants that it would not issue advice to the effect that an entity holding a single swap would not be a commodity pool. Furthermore, nothing in the current structure of investment vehicles currently operated by CPOs suggests that their investments follow any narrowly defined pattern. The courts have interpreted “commodity pool,” as defined in previous CFTC regulations, more narrowly. The court in the 1986 Ninth Circuit case Lopez v. Dean Witter Reynolds, Inc.5 stated:
Those courts which have raised the issue require the following factors to be present in a commodity pool: (1) an investment organization in which the funds of various investors are solicited and combined into a single account for the purpose of investing in commodity futures contracts; (2) common funds used to execute transactions on behalf of the entire account; (3) participants share pro rata in accrued profits or losses from the commodity futures trading; and (4) the transactions are traded by a commodity pool operator in the name of the pool rather than in the name of any individual investor.
This definition has generally been followed by the courts. The decision that the investment vehicle in Lopez was not a commodity pool rested largely on the third element and the fact that different investors were allocated different commodity interests based on their particular circumstances. It did not turn on whether the vehicle was trading or merely investing. Nevertheless, the third element in the Lopez test may present an argument that a securitization structure, which typically pays all investors, other than investors in one residual class, a principal amount plus interest, rather than a share of the profits,6 should not be regarded as a commodity pool.
Given that the Lopez decision interpreted CFTC regulations rather than the CEA, it is unclear to what extent the tests enunciated in that case are still applicable, in light of the CFTC’s current broad interpretation of the definition of “commodity pool.” It is also unclear, however, whether prior CFTC interpretations governing commodity pools would remain applicable to a securitization trust holding just one swap. The introduction of swaps into the definition of “commodity pool” may create an issue of first impression when interpreting the concept of “trading” in commodities. Swaps are commonly entered into by securitization vehicles for purposes of hedging risk (including the matching of interest rates or currencies relating to the assets held in the vehicle to the interest rates or currency of liabilities issued by the vehicle) rather than with a view to profit or loss on the swap itself. It is arguable that Congress could not have intended to bring such vehicles, which use swaps purely for hedging and not trading for profit, into the world of commodity pool registration and regulation. Nevertheless, it is quite possible that the CFTC will develop a broad definition of “commodity” and “commodity pool” as part of an effort to effectively bring swaps within its jurisdiction.
The new CFTC rules do provide certain exemptions, including, in particular, an exemption from registration for operators of certain investment trusts whose securities were sold pursuant to an exemption from the registration requirements of the Securities Act of 1933 (1933 Act), and which engage in a de minimis amount of swap activity.7 The tests in such exemption appear to be focused on more traditional commodity pools, however, and the application of the exemption to securitization vehicles is unclear absent further interpretive guidance from the CFTC. Further, since it is CPOs and CTAs who have to register, rather than the commodity pools themselves, an operator or advisor can avoid registration only if it has a registration exemption for every relationship it has with a commodity pool, or if it is one of the types of entities generally excluded from the registration requirement, namely a bank, an insurance company or a registered investment company.
Swaps That Are Captured by the New Rule
The Dodd-Frank Act added a definition of “swap” to the CEA8 that broadly defined the term and specifically includes interest rate swaps, currency swaps, total return swaps and credit defaults swaps, but specifically excludes most “security-based swaps,” namely swaps that relate to the performance of individual securities or loans and narrow-based securities indexes, and are therefore subject to the jurisdiction of the SEC. Certain other products, such as many types of insurance, loan participations and contractual provisions in loans that might otherwise fall within a broad reading of the term “swap” have been excluded by the Swap Definition Rule. Accordingly, products whose presence can create a commodity pool are generally those that (i) are the types of products specifically identified in the definition of “swap,” (ii) are not security-based swaps and (iii) are not otherwise excluded by the Swap Definition Rule.
Identifying the Relevant Commodity Pool
The definition of “commodity pool” would appear to apply on an entity basis, even though commodity pools themselves are not subject to direct regulation. If a securitization trust or similar entity holds a swap, even if the swap benefits just one class of the securities issued by the entity, the entity as a whole (rather than the one class) is subject to being regarded as a commodity pool. If a separate trust is formed to hold one class of securities and a swap, that separate trust could be a commodity pool. If interests in that trust are held by just one investor, however, so that same result could be achieved by selling the swap directly to the investor rather than to the securitization trust, it is arguable that the trust should not be characterized as a commodity pool, but there is no precedent available to support that conclusion.
Identifying the Commodity Pool Operators
The CEA defines a CPO as a person involved with a commodity pool or similar enterprise who “solicits, accepts, or receives from others, funds, securities or property, either directly or through capital contributions, the sale of stock or other forms of securities, or otherwise, for the purpose of trading in commodity interests …” It would therefore appear to encompass a sponsor and depositor in a typical securitization structure, as the parties arranging for the initial sale of the securities of the entity and the acquisition of the assets.
CFTC interpretations have also identified the party with authority to change the commodity pool’s CTA as a possible CPO.9 It is unclear how that test would be applied in the context of a securitization, particularly where the pool of assets is fixed and the only active roles are those of one or more servicers and, to the extent of distributions, reporting and securities transfers, a trustee or securities administrator. None of such entities make investment decisions for the entity. Even in the context of collateral managers utilized in most collateralized loan or debt obligation structures, where there may be more active management of underlying assets, the decisions with respect to the assets are made by an investment manager engaged by contract and generally not subject to change absent breach of that contract.
Registering as a Commodity Pool Operator or Commodity Trading Advisor
To register, a CPO or CTA must register with the National Futures Association (NFA) by filling out Form 7-R and paying a fee and membership dues. Its principals and certain employees must complete Form 8-R, have their fingerprints taken, and pay certain fees and, as to associated persons (some of whom may be principals), pass the Series 3 examination (with some exceptions). Offering documents for commodity pools operated by the CPO or advised by the CTA must contain certain specified boilerplate disclosure language and specific information about the pool. Monthly (or quarterly, depending on the size of the pool) and annual reports must generally be provided to the investors in the commodity pool, as well as to the NFA.
The Consequences of Failing to Register as a Commodity Pool Operator
CPOs that fail to register are subject to fine, disgorgement of earnings and the rescission of agreements with investors. In addition, if an investment vehicle is a commodity pool that is required to be, but is not, operated by a registered CPO, it will not satisfy the definition of “eligible contract participant,” making participation in OTC swaps impossible. Further, if a company is required to register as a CPO, individuals associated with the company may be liable for failing to register as associated persons of that company.
In a Standard Securitization, the Information Required to be Provided to Investors in a Commodity Pool Is Not Useful
Assuming that a standard securitization vehicle would likely have only one interest rate or currency swap, the information that the SEC requires be provided to investors in a commodity pool is not likely to be useful at all; even if it is useful, it may well be otherwise provided to the investors to satisfy other statutory or regulatory requirements. For example, over the life of the securitization vehicle, there will probably be no realized and unrealized gains and losses on the swaps, since they are not traded, and if they must be replaced or novated, any gain or loss is generally absorbed in securing a replacement swap and is in any event neither passed through to investors nor treated as a potential source of gain or loss in the offering materials. Advisory and management fees will have been specified in advance (most likely in a discussion of servicing or management fees and costs), and brokerage commissions will be rare or nonexistent. A securitization structure will not normally be regarded as having something akin to a net asset value, since such a value would not provide the basis for recurring redemptions or new admissions to the investor group of the securitization vehicle. The same can be said of “the total value of the participant’s interest or share in the pool as of the end of the reporting period.”10 These concepts just do not exist in a typical securitization.
The Volcker Rule Implications of the Commodity Pool Definition
Under the regulations proposed to implement the portion of the Dodd-Frank Act referred to as the Volcker Rule, commodity pools are treated as “covered funds.” Unless such proposed regulations are changed or otherwise clarified, this would subject entities affiliated with insured depository institutions and non-US banks with branches and agencies in the US to ownership and affiliate transaction restrictions with respect to any securitizations that are treated as commodity pools.
It is unclear whether the availability to certain non-US banking organizations of an exemption for funds that are “solely outside of the United States” would be affected if such funds enter into swaps with US counterparties. The fact that the phrase “solely outside of the United States” typically refers only to locations outside the US and to absence of any offer or sale of interests in the fund in the US may support the availability of the exemption in such circumstances.
Under the proposed regulations for the Volcker Rule, securitizations of loans are exempt from the prohibitions on sponsorship or ownership of covered funds by banking entities, notwithstanding that such covered funds hold a limited amount of swaps used solely for hedging. It is unclear whether the express intent of the Volcker Rule, both in the statute and proposed regulations, to exclude such securitizations from regulation notwithstanding the presence of such swaps can be taken as an indication of Congressional intent to exclude securitizations holding swaps for such purpose from regulation as commodity pools.
The Absence of Guidance from the CFTC
Industry participants have contacted the CFTC to seek no action letters or interpretive advice, but to date no such relief has been provided.11 Registration of all sponsors and operators of existing securitization vehicles with swaps as CPOs or CTAs by October 12th is clearly impractical, and accordingly industry participants are hopeful that the CFTC will provide some relief before that deadline. Such relief, if provided at all, may be in the form of an extension for compliance rather than guidance enabling such sponsors and operators to conclude no registration is necessary.
Industry participants continue to seek guidance from the CFTC, but face reluctance on the part of the CFTC to give no action or other interpretive relief which could be interpreted to limit its jurisdiction or authority. Accordingly, unless relief is forthcoming in the near future, either:
- Industry participants, with advice of their attorneys, must decide whether they can conclude that the relevant investment vehicle either is not a commodity pool, despite the presence of one or more swaps, or qualifies for the de minimis exemption from CPO registration discussed in footnote 7, or
- Registration of the investment vehicle’s CPOs will be required.
Since registration will result in certain reporting and compliance obligations, new CPOs will also need to obtain background data on commodity pools they already operate and quickly put into place new reporting and compliance systems to accommodate new regulatory requirements.