The CFTC amended Regulation 4.5 so it no longer provides an exemption from CFTC registration for those running investment pools and falling under the CPO definition but who are regulated elsewhere (e.g. in the UK by the FSA). Instead UK fund managers must squeeze into another exemption, for example, by showing that their funds’ commodity investments and/or swaps meet the narrow bona fide hedging purposes test.
The changes and applicable rules are complex. Whilst we have summarised our understanding of them here, UK fund managers will need to take US legal advice to determine their application (taking into account any possible exemptions) and to assess the impact on their funds. The changes have been met with significant criticism due to the increased regulatory burden and are currently being challenged in the United States (see below). UK fund managers may wish to consider challenging the rules themselves (perhaps through their trade association), and we would be happy to discuss this further with anyone who might be interested.
What are the new rules?
By defining a ‘commodity pool’ as any enterprise operated for the purpose of trading in commodity interests, including swaps, and then widely defining which agreements/contracts/ transactions are seen as swaps, the revised provisions of the CEA have significantly expanded the number of firms who can be defined as a CPO. Even firms managing funds engaged in swaps not directly related to commodities, such as standard currency or interest rate swaps, will now be caught by the definition.
If a firm is considered a CPO it must register with the CFTC unless it can establish an exemption. However, it has also become harder for firms to establish such an exemption. CFTC Regulation 4.5 has now been reverted back to its pre-August 2003 position, removing the exemption from CFTC registration if a fund manager which meets the CPO definition of “otherwise regulated” (e.g. if regulated in the UK by the FSA). To be exempt going forward, the fund must be a registered investment company under the Investment Company Act of 1940, as amended, and can only use commodity futures, options on futures contracts and swaps for bona fide hedging purposes, unless, for those positions which do not meet the bona fide hedging purposes criteria, (i) the aggregate initial margin and/or premiums for the positions do not exceed 5% of the liquidating value of the fund’s portfolio, and (ii) the aggregate net notional value of commodity futures, options or swaps positions do not exceed 100% of the liquidation value of the fund’s portfolio. In addition, a registered investment company claiming relief under Regulation 4.5 cannot be marketed as a participant in a commodity pool or as a vehicle for trading commodity futures or options.
There is also a de minimis exemption under Regulation 4.13(a)(3) which will only apply if for each of the pools the CPO is claiming exemption from the interests in the pool are exempt from registration under the Securities Act of 1933, as amended. In addition to this the pool must satisfy one of two of the tests referred to above with the difference being that all positions are to be considered, not just those entered into for non-bona fide hedging purposes. This exemption is further restricted by limiting the class of persons who may invest in the fund, primarily to those with knowledge of investing.
If a CPO for a non-US pool is unable to fall within the exemptions from registration there are still potentially two reliefs available which disapply the key disclosure and reporting requirements brought about by registration. Under CFTC Regulation 4.7, where all of a pool’s participants meet the definition of a “qualified eligible person” contained in the CEA, the registered CPO will be subject to “lite touch” requirements. A “Non-United States person” is a “qualified eligible person” and includes both individuals who are non-US residents and corporations/entities registered outside the United States and having their principal places of business outside the United States. A CPO making use of this relief does not need to comply with the rules regarding delivery of disclosure documents and the provision of monthly Account Statements, amongst other exemptions.
A further relief was granted under CFTC Advisory 18-96, which states that a registered US CPO who operates a non-US commodity pool is exempted from the majority of the disclosure and reporting requirements under the CFTC regulations in respect of that pool. A non-US pool is a commodity pool which is organised, operated and administered outside the United States, with no investors being a “US person”, no sources of capital have come from the United States and no marketing activities are conducted which are to have the effect, or could reasonably be expected to have the effect, of soliciting participation from a “US person”.
What are the implications of this?
The changes mean that many UK investment managers operating funds that trade in commodities and swaps will be required to register with the CFTC as CPOs, become a member of the National Futures Association (“NFA”) and comply with the regulatory regimes which are associated with these steps. The precise impact may vary depending on the activities of the CPO.
The key impacts of full registration as a CPO are as follows:
Separation – a CPO must operate its pool as a separate legal entity from the CPO and all funds, securities or other property received from existing or prospective investors for the purchase of an interest in the pool must be received in that pool’s name. In addition there can be no commingling of any pool’s property with that of another person.
Disclosure – A CPO must prepare and file a Disclosure Document with the NFA. In most instances this Disclosure Document must be delivered to a prospective investor prior to sending a subscription agreement. A fund will not be able to accept any funds received from the investor without first receiving an acknowledgement that the investor has received the Disclosure Document. The document itself must contain a number of disclosure statements including those relating to risk factors, fee disclosures (with a break-even analysis) and performance disclosures.
Reporting – CPO registration obligates a fund, in most cases, to prepare and distribute monthly or quarterly Account Statements (which depends on the size of the fund) as well as an Annual Report to its investors. These are required to contain specific financial information about the fund and its performance, and should comply with GAAP.
NFA and CFTC Inspection Powers – the NFA has the authority to conduct on-site audits on CPOs as a means of monitoring compliance. The timing and frequency of these audits varies according to a number of factors published by the NFA including the amount of money a firm has control of and the level of customer complaints a firm has received. In addition to this, the CFTC has the power to inspect books and records that a firm is required to hold under the CEA or CFTC regulations.
Challenge in the United States
The change to the regulation is the subject of a challenge in the U.S. District Court for the District of Columbia. The Investment Company Institute (‘ICI’) has brought the challenge on behalf of its members, arguing that the change is “arbitrary and capricious”. The ICI believe that the CFTC violated several acts in implementing the change and failed to conduct a proper cost-benefit analysis of the changes.
The ICI has concerns that the amendment will cause mutual and exchange traded funds unnecessary regulation in a manner sometimes contradictory with existing regimes. They are concerned that, as these funds are some of the most regulated under federal securities law, the additional burden will cause added confusion for investors, increase costs, reduce investor choices and ultimately duplicate the existing regulatory regime.