CFTC Changes Rules Affecting Public And Private Funds

INTRODUCTION

The Commodity Futures Trading Commission (CFTC) on February 9, 2012 adopted final rules under the Commodity Exchange Act as amended (CEA) that modify and eliminate certain CFTC registration exclusions and exemptions widely used by sponsors of investment companies registered under the Investment Company Act of 1940 as amended (1940 Act) (mutual funds) and private investment funds.1 These rule changes will result in significant changes to the manner in which both public and private funds using commodity futures, commodity options and many derivatives will be offered, operated, and regulated, as well as result in significant costs to those funds and their advisers. Every public and private adviser will need to evaluate its business and operational and compliance infrastructures in light of these changes.

In summary, the final rules:

reinstate and expand the trading and marketing criteria necessary for advisers to mutual funds to qualify under CFTC Regulation 4.5 for an exclusion from the definition of commodity pool operator (CPO); rescind the exemption under CFTC Regulation 4.13(a)(4) from CFTC registration for CPOs to commodity pools privately offered solely to qualifying investors; modify the criteria for claiming the exemption under CFTC Regulation 4.13(a)(3) from CFTC registration for CPOs to commodity pools with very limited use of commodity interests, but otherwise retain Regulation 4.13(a)(3); require all persons that claim exclusionary or exemptive relief under CFTC Regulations 4.5, 4.13, and 4.14 from CPO or commodity trading advisor (CTA) registration (respectively) to reconfirm their qualifications annually on a calendar-year basis, commencing with the calendar year ending December 31, 2012; modify the reporting requirements and participant qualification criteria for CPOs and CTAs relying on CFTC Regulation 4.7; require CPOs and CTAs that are registered with the CFTC to file certain new reports on Form CPO-PQR and Form CTA-PR (respectively) regarding their commodity trading activities;2 and amend the standardized risk disclosure required to be included in CPO and CTA disclosure documents to describe certain risks of swap transactions. In addition, the CFTC proposed certain harmonization provisions in order to facilitate compliance by mutual funds with the CFTC's disclosure, reporting, and recordkeeping provisions by attempting to align the CFTC's requirements with those placed on mutual funds by the Securities and Exchange Commission (SEC).

Dechert LLP, on behalf of itself and many affected clients, commented extensively on these regulations as proposed.3 Additionally, Dechert published multiple client alerts on this regulatory initiative.4

CFTC REGULATION 4.5

CFTC Regulation 4.5 currently excludes a mutual fund and its operator and other entities from the definition of a CPO. The amendments reinstate and expand pre-2003 regulations for purposes of determining whether a mutual fund may rely upon the exclusion. Specifically, the amendments condition a mutual fund's reliance upon the Regulation 4.5 exclusion on certain trading thresholds and marketing restrictions (as discussed below). An adviser to a mutual fund unable to meet these limitations will be required to register as a CPO and submit to regulation by the CFTC and the National Futures Association (NFA).

New Conditions

Under the final rules, to rely on the exclusion in Regulation 4.5, a mutual fund must represent that:

with respect to exchange-traded commodity futures, options on such futures, and commodity options and over-the-counter (OTC) swaps (commodity interests) used for purposes other than solely bona fide hedging purposes (as determined under CFTC Regulations 1.3(z)(1) and 151.5),5 either: the aggregate initial margin and premiums required to establish the mutual fund's positions in such instruments will not exceed 5% of the liquidation value of the mutual fund's portfolio (after accounting for unrealized profits and unrealized losses on such instruments)6 (5% Trading Test); or the aggregate net notional value of such instruments, determined at the time of the most recent position established, does not exceed 100% of the liquidation value of the mutual fund's portfolio (after accounting for unrealized profits and unrealized losses on such instruments) (Net Notional Test);7 and the mutual fund will not be, and has not been, marketing participations in the mutual fund to the public as a "commodity pool"8 or otherwise as a vehicle for trading in commodity interests (Marketing Restriction).9 The discussion below describes the amendments originally proposed by the CFTC on January 26, 2011,10 comments received on the proposal and highlighted in the Adopting Release, and how the amendments that were adopted differed from the proposal.

Overview of Proposed Amendments

In August 2010, the NFA petitioned the CFTC to amend Regulation 4.5.11 The NFA requested that the CFTC place limitations on the then-existing blanket exclusion for mutual funds under Regulation 4.5, thereby requiring mutual funds with greater than de minimis investments in commodity interests to register and be regulated as CPOs. Limitations similar to those proposed by the NFA were in place prior to 2003.

Under Regulation 4.5 as in effect prior to 2003, a mutual fund could qualify for the CPO exclusion only if its commodity interest trading was (i) conducted solely for bona fide hedging purposes as defined by Regulation 1.3(z)(1),12 or (ii) if not conducted for bona fide hedging purposes, the aggregate initial margin and premiums for those positions could not exceed 5% of the liquidation value of the mutual fund's portfolio after taking into account unrealized profits and unrealized losses on such positions (Pre-2003 5% Trading Test).13 In addition, the mutual fund could not be marketed as a commodity pool or vehicle for trading in commodity interests (Pre-2003 Marketing Restriction), but this restriction did not extend to trading in swaps or other OTC instruments providing indirect exposure to the commodity markets.

In 2003, the Pre-2003 5% Trading Test and the Pre-2003 Marketing Restriction were removed. The CFTC's rationale in doing so was "to encourage and facilitate participation in the commodity interest markets by additional collective investment vehicles and their advisers, with the added benefit to all market participants of increased liquidity."14 Those desired goals have been achieved with significant benefits to the markets and investors. Moreover, the investor demand for asset diversification and commodity exposure has resulted in substantial growth of mutual funds utilizing derivatives. Accordingly, prior to the recently-announced amendments, Regulation 4.5 had not limited the amount of commodity interest trading a mutual fund could conduct in order to qualify for the CPO exclusion.15

Comments and Rules Adopted

The CFTC received numerous comments on its proposed amendments to Regulation 4.5, including: the 5% Trading Test; the Marketing Restriction; the appropriate person to register as a CPO; the use of mutual fund subsidiaries in the form of "controlled foreign corporations" (CFCs); and regulatory harmonization and implementation issues.

5% Trading Test and Alternative Net Notional Test

With respect to the proposed trading threshold, the CFTC received comments seeking certain exclusions and proposing alternatives. The CFTC rejected commenters' requests for exclusion from the threshold calculation for various broad-based stock index futures (e.g., futures on the S&P 500 Index), security futures generally, and financial futures contracts as a whole. The CFTC also rejected requests for an expansion of the definition of bona fide hedging to include risk management for purposes of Regulation 4.5, stating that the CFTC believes there is an important distinction between bona fide hedging transactions and risk management transactions. According to the CFTC, bona fide hedging transactions are unlikely to present the same level of market risk as risk management transactions because bona fide hedging transactions are offset by exposure in the physical markets. Further, the CFTC expressed concern that excluding risk management transactions from the trading threshold calculation would permit mutual funds to engage in a greater volume of derivatives trading than other entities that engage in the same activities but are required to register as CPOs.16

Among other alternatives suggested, in a July 2011 comment letter on the proposals, Dechert proposed that the CFTC consider adopting an alternative to the 5% Trading Test that would be similar to the "aggregate net notional value test" currently available to CPOs claiming an exemption from registration as CPOs under CFTC Regulation 4.13(a)(3)(ii)(B).17 In response, the CFTC adopted this alternative test, stating that it "no longer believes that its prior justification for abandoning the alternative net notional test is persuasive."18 The CFTC further stated that it "believes that the adoption of an alternative net notional test will provide consistent standards for relief from registration as a CPO for entities whose portfolios only contain a limited amount of derivatives positions and will afford [mutual funds] with additional flexibility in determining eligibility for exclusion."19

Marketing Restriction

The CFTC agreed with commenters that the proposed inclusion of the clause "or otherwise seeking investment exposure to" in the Marketing Restriction would introduce an unacceptable level of ambiguity into the restriction, and accordingly removed this clause from the final rule. However, the final Marketing Restriction remains broad and invites a second-guessing of mutual fund sponsors' conclusions as to whether their funds meet the test.

To address comments seeking guidance on what factors the CFTC would consider in determining whether a mutual fund triggered the Marketing Restriction, the CFTC...