The Commodity Futures Trading Commission, by a 4 - 1 vote, has sharply narrowed the exemptions from commodity pool operator status that are available with respect to registered investment companies and private funds. The controversial rulemaking action was taken in a seriatim vote without a public meeting, a procedure more commonly used for far more routine matters. The CFTC in January 2011 proposed the rule amendments in a public meeting whose meeting notice gave no hint of its purpose, so there does seem to be a consistent pattern of the CFTC preferring these actions to be below the radar. The CFTC has also proposed rule amendments intended to harmonize its CPO requirements applicable to registered investment companies with the requirements of the Securities and Exchange Commission. Both actions were taken on February 8, but not announced until a February 9 press release.
For both RICs and private funds, the rule amendments reverse broad exemptions adopted in 2003 and ostensibly return them to the narrower exemptions that were available prior to that time. However, due to the increased use of derivatives since 2003 and the Dodd-Frank Act's expansion of CPO regulation to include swaps, there will be considerably more mutual funds, exchange-traded funds, and hedge funds affected than was the case under the pre-2003 regime. The amendments will require the investment advisers to affected funds to register as CPOs (and, typically, as commodity trading advisors) and to become members of the National Futures Association. Examination and registration of their associated persons will also be required. Assigning CPO responsibilities to mutual fund advisers is a change in position from the past, when the registered investment company itself was considered the commodity pool operator. That was problematic in part because it would have required the examination and registration of independent fund directors.
A "commodity pool" generally is any investment trust, syndicate, or similar form of enterprise operated for the purpose of trading in commodity interests, and a "commodity pool operator" is a person engaged in a business that is of the nature of a commodity pool. Under 17 C.F.R. § 4.5 as amended by the CFTC, a registered investment company is excluded from the definition of a CPO, but only if the RIC annually files a notice of exclusion and is able to make three representations. First, the RIC must limit its use of commodity futures, commodity options contracts, and swaps to bona fide hedging purposes, plus an additional amount such that the aggregate initial margin and premiums required to establish such positions will not exceed 5% of the portfolio, after taking into account unrealized profits and losses. "Bona fide hedging purposes" does not mean risk management transactions; it is a narrowly defined standard that RIC and private fund transactions typically will not meet.
Second, the aggregate net notional value of commodity futures, commodity options contracts, or swaps positions not used solely for bona fide hedging purposes must not exceed 100% of the liquidation value of the pool's portfolio, after taking into account unrealized profits and losses. The preamble to the rule implies that this is an alternative standard, such that the exemption is available if either the 5% test described in the preceding paragraph or this 100% test is met. The actual rule language, however, requires that both tests be met. If the preamble really reflects the CFTC's intention, perhaps the rule language will be corrected when it is published in the Federal Register, or at some later time.
The third requirement is that the RIC must not be marketed to the public as a commodity pool or otherwise as a vehicle for trading in the commodity futures, commodity options, or swaps markets. The proposal also included a prohibition on "otherwise seeking investment exposure to" those markets, but the CFTC deleted that language as only creating uncertainty. The preamble to the rule lists several factors that are indicative of marketing the RIC as a vehicle, but says that such factors should be instructive and that no single factor is dispositive. The CFTC will not consider the mere disclosure to investors or potential investors that the RIC may engage in derivatives trading incidental to its main investment strategy and the risks associated therewith as being violative of the marketing restriction.
Among the nondispositive factors indicative of marketing is the use of a controlled foreign corporation. Many RICs do use CFCs, typically Cayman Islands corporations, as vehicles for investing in derivatives while meeting tax law requirements. In addition to being a factor indicative of marketing, CFCs now will themselves be subject to commodity pool status, even when their parent RIC qualifies for an exemption (unless the CFC also qualifies for an exemption, which typically will not be the case). It appears likely, therefore, that any investment adviser to a RIC with a CFC will have to register as a CPO, except in cases where the adviser's responsibilities do not include the CFC.
The CFTC also rescinded 17 C.F.R. § 4.13(a)(4), which provided an exemption from CPO status with respect to commodity pools whose participants were all qualified eligible persons (a counterpart to the "qualified purchasers" who can invest in private funds under Section 3(c)(7) of the Investment Company Act of 1940). The rescission may be particularly onerous for foreign CPOs operating a pool with at least one U.S. investor; such foreign CPOs will be required to register with the CFTC even if foreign regulators also oversee their activities. The CFTC did, however, retain Rule 4.13(a)(3), which provides exemptions generally similar to those available with respect to RICs under Rule 4.5.
Compliance with Rule 4.5 for registration purposes only will be required not later than the later of December 31, 2012, or 60 days after the effective date of a final rulemaking further defining the term "swap," which the CFTC will publish in the Federal Register at a future date. Entities required to register due to the amendments to Rule 4.5 will be subject to the CFTC's recordkeeping, reporting, and disclosure requirements within 60 days following the effectiveness of a final rule implementing the CFTC's proposed harmonization effort pursuant to the concurrent proposed rulemaking. CPOs claiming exemption under Rule 4.13(a)(4) will be required to comply with its rescission by December 31, 2012; however, compliance shall be required for all other CPOs 60 days from publication in the Federal Register. Comments will be due on the harmonization proposal 60 days after its publication in the Federal Register.
CFTC Commission Scott O'Malia, in a statement of concurrence, justified the rule amendments in part by pointing to the failure of MF Global Inc. and its large shortfall in segregated futures customer funds. This rationale is a bit ironic, since MF Global was registered with the CFTC as a futures commission merchant, while no RIC has ever had a comparable shortfall of customer assets. Commissioner Jill Sommers, the lone dissenter from the rulemaking action, noted that there is no evidence to suggest that inadequate regulation of commodity pools was a contributing cause of the 2007 - 2008 financial crisis or that subjecting entities to a dual registration scheme will somehow prevent a similar crisis in the future. She stated that it is unlikely, in her view, that the cost-benefit analysis supporting the rules will survive judicial scrutiny if challenged - seemingly an invitation to such a challenge.
The CFTC press release, with links to both rulemaking actions and to various other documents, is available at
For the most recent FundLaw post on the proposal, see
John M. Baker <JMB@...
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