Recently, the Commodity Futures Trading Commission (CFTC) held an open meeting to release for public comment certain rules relating to the regulation of entities participating in the futures and derivatives markets. The CFTC is proposing to:

  • reinstate the trading criteria for registered investment companies (RICs) claiming exclusion from the definition of commodity pool operator (CPO) under CFTC Regulation 4.5;
  • eliminate the exemptions from CPO registration included in CFTC Regulations 4.13(a)(3) and 4.13(a)(4);
  • require CPOs and commodity trading advisors (CTAs) that claim relief under CFTC Regulations 4.5, 4.13 and 4.14 to confirm their notice of claim of relief annually; and
  • revise Regulation 4.7 so that CPOs may not be exempt from requirements to include audited financial statements in annual reports, and to modify the qualified eligible person (QEP) qualification criteria.

Trading Criteria Under CFTC Regulation 4.5

Currently, CFTC Regulation 4.5 generally provides an exclusion from the definition of CPO for entities that are already regulated by another regulatory authority. Pursuant to this exclusion, regulated entities such as RICs, insurance companies and banks that trade some level of futures interests and otherwise would have been required to register as CPOs receive relief from CFTC registration, and the sponsored pools are exempt from CFTC disclosure, reporting and record-keeping requirements.

Prior to 2003, an entity claiming the Regulation 4.5 exclusion was required to file a notice of eligibility and represent that the sponsored pool i) would not be and had not been marketing itself to the public as a vehicle for trading in the commodity futures or commodity options markets, and ii) would cap the use of commodity futures or commodity options contracts for non-bona fide hedging purposes to five percent of the liquidation value of the entity’s portfolio. Beginning in 2003, these trading criteria were eliminated.

According to the CFTC’s materials related to the rule proposal, during 2010, the CFTC expressed concern with respect to certain RICs that were offering sales of “de facto commodity pool interests” and claiming exclusion under Regulation 4.5. The National Futures Association (NFA) submitted a petition for rulemaking proposing the reinstatement of the pre-2003 trading criteria, and the CFTC is now proposing to amend Regulation 4.5 in a manner consistent with the NFA’s petition. If the trading criteria are reinstated, regulated entities such as RICs will no longer be able to claim an exemption from CPO registration if they market themselves as a vehicle for trading in commodity futures or if they have significant exposure to commodity futures or commodity options contracts. RICs and other regulated entities with significant futures exposure will be required to register as CPOs and, subject to the availability of certain other regulatory relief, will be required to comply with the disclosure, reporting and record-keeping requirements included in the CFTC Regulations.

What does this mean if you operate a mutual fund that invests in futures interests?

Mutual funds that invest in futures interests have typically requested relief under CFTC Regulation 4.5. Under Regulation 4.5, commodity pool operators that are already regulated by a different regulatory authority are excluded from the definition of CPO, and therefore are not subject to the CFTC’s requirements for registered CPOs. However, if the CFTC’s proposed rules are adopted, RICs that invest in more than a de minimus amount of futures interests will not be excluded from the definition of CPO, since they will have commodities exposure in excess of the five percent limit. Accordingly, the operators of these commodity mutual funds will be required to register as CPOs and, absent other relief, will be required to have the RIC comply with the CFTC’s disclosure, record-keeping and reporting requirements.

Currently, the CFTC’s requirements for commodity pools conflict in several material respects with the SEC’s rules relating to RICs. For example, CFTC-regulated commodity pools are required to receive a signed acknowledgment that a prospective investor has received a copy of the disclosure document before the prospective investor’s investment can be accepted by the pool, while mutual fund shares may be purchased by an investor without such a signed acknowledgement, including online, even though a prospective purchaser is required to receive a copy of the mutual fund’s prospectus before or at the time of purchase. Mutual funds and commodity pools also have different requirements with respect to the disclosure of performance information. For instance, commodity pool operators are required to disclose the performance of other accounts to prospective investors, including accounts using different investment strategies, while SEC rules and regulations prohibit the disclosure of performance information for other accounts advised by a mutual fund’s adviser in a mutual fund’s prospectus that are not substantially similar to the mutual fund. As such, it will be necessary for the SEC and CFTC to provide additional guidance for the operators of mutual funds that are required to register as CPOs if Regulation 4.5 is amended as proposed.

Elimination of Exemptions Under CFTC Regulations 4.13(a)(3) and 4.13(a)(4)

The CFTC also proposes to rescind the exemptions from CPO registration under CFTC Regulations 4.13(a) (3) and 4.13(a)(4). Currently, Regulation 4.13(a)(3) provides an exemption from CPO registration for operators of pools that trade a minimal amount of commodity interests and meet certain investor suitability standards. Regulation 4.13(a)(4) essentially provides an exemption from CPO registration for operators of pools in which all investors are QEPs,1 and the interests in the pool are offered pursuant to a private placement. As a consequence, any alternative investment fund that trades even a single future will generally be required to register with the CFTC as a CPO.

What does this mean if you operate a 3(c)(7) fund that invests in futures?

If CFTC Regulation 4.13(a)(4) is rescinded as proposed, the operator of any 3(c)(7) fund that invests any assets in futures interests will be required to register as a CPO with the CFTC. Since 3(c)(7) funds are required to have only investors that are “qualified purchasers,” the operator of a 3(c)(7) fund that invests in futures interests should be able to receive relief under CFTC Regulation 4.7.2 CPOs that are exempt pursuant to Regulation 4.7 are relieved from most of the disclosure, reporting and record-keeping requirements, although, as discussed below under “CFTC Regulation 4.7,” if the CFTC’s proposals are implemented, CPOs claiming relief under Regulation 4.7 would not be able to claim exemptive relief from the requirement to include audited financial statements in the pool’s annual report.

 What does this mean if you operate a 3(c)(1) fund with nominal futures exposure?

Currently, the sponsor of a 3(c)(1) fund that has de minimus exposure to futures interests is exempt from registration as a CPO under CFTC Regulation 4.13(a)(3). If Regulation 4.13(a)(3) is rescinded, sponsors of 3(c)(1) funds that invest any amount of their assets in futures interests will be required to register as CPOs with the CFTC, and, absent other exemptive relief, will be required to comply with the CFTC’s disclosure, reporting and record-keeping requirements for offered pools.

In order to avoid the CFTC’s disclosure and NFA filing requirements, sponsors of 3(c)(1) funds with exposure to futures interests will need to rely on CFTC Regulation 4.7. However, the investor suitability requirements under Regulation 4.7 are materially higher than the requirements under Section 3(c)(1) of the Investment Company Act of 1940.

Annual Confirmation of Notice of Exclusion/Exemption

Currently, anyone claiming exclusion/exemption under CFTC Regulation 4.5, 4.13 or 4.14 may file a one-time notice filing in order to receive the appropriate exclusion or exemption. Under the CFTC’s proposal, however, all such persons claiming exemptive or exclusionary relief under these CFTC Regulations will have to confirm their claim of relief annually.

CFTC Regulation 4.7

Regulation 4.7 provides relief from certain reporting, disclosure and record-keeping requirements for the operators of pools that offer interests solely to QEPs. The CFTC has proposed two changes that would affect Regulation 4.7:

  1. CPOs claiming relief under Regulation 4.7 would not be able to claim exemptive relief from the requirement that the pool’s annual report contain audited financial statements.
  2. The QEP qualification criteria will be modified to incorporate the SEC’s definition of “accredited investor” by reference, rather than by direct inclusion. The SEC is currently examining and modifying the standards for “accredited investor” status, and incorporation by reference will allow the CFTC’s definition of QEP to be adjusted automatically in the event that the “accredited investor” standards are adjusted by the SEC, without requiring an additional amendment to CFTC Regulation 4.7.