Proposal to Rescind CFTC Registration Exemptions Will Affect Many Public and Private Investment Funds

The Commodity Futures Trading Commission ("CFTC") on January 26, 2011 released for public comment the latest in a series of proposed regulations under the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank").1 The proposed regulations, in addition to expanding CFTC compliance obligations for certain commodity market participants, would eliminate certain CFTC exclusions and exemptions widely used by sponsors of private investment funds and registered investment companies ("RICs").

The CFTC proposes to:

reinstate and expand the trading and marketing criteria necessary for RICs and certain other persons to qualify for the CFTC Regulation 4.5 commodity pool operator ("CPO") exclusion; rescind registration exemptions available for CPOs offering commodity pools to sophisticated and creditworthy investors under CFTC Regulations 4.13(a)(3) and 4.13(a)(4); require all persons that claim exemptive or exclusionary relief from CPO or commodity trading advisor ("CTA") registration under CFTC Regulations 4.5, 4.13 or 4.14 to re-confirm their qualifications annually; require CPOs and CTAs that are registered solely with the CFTC to file certain new reports regarding their commodity trading activities; implement a change to the reporting requirements and the criteria for participant qualification for CPOs and CTAs relying on CFTC Regulation 4.7; and amend the risk disclosures included in CPO and CTA documents to describe certain risks of swap transactions.2 Although not explicitly mandated by Dodd- Frank, the CFTC has stated that the proposals are "consistent with the tenor of the provisions of the Dodd-Frank Act" in that they will give the CFTC more oversight of market participants and a more comprehensive view of commodity market risk.3 Some elements of the proposals are intended to create corresponding CFTC regulation to new Dodd-Frank-related regulation of investment advisers by the Securities and Exchange Commission ("SEC"). If and when adopted, the CFTC's proposals would bring sweeping changes to registered and private funds participating in the commodity markets.

Background on CPO and CTA Regulation

As amended by Dodd-Frank, a CPO is a person that sponsors, solicits participation in, or operates a collective investment vehicle ("pool") that trades exchange-traded futures contracts, options thereon, or commodity options, commodity swaps and other over-the-counter ("OTC") derivatives, certain foreign currency transactions, certain leverage transactions or interests in other commodity pools ("commodity interests").4 In practice, a CPO is usually the general partner of a limited partnership, the managing member of a limited liability company, the directors of a corporation, the trustees of a trust, or the investment adviser of a non-U.S. company. Unless excluded from the CPO definition or exempted from some or all of the CPO regulatory requirements, a CPO must (among other things):

register with the CFTC through the National Futures Association ("NFA");5 become a member of the NFA; include specified disclosures (including but not limited to risks, conflicts, fees and costs, and performance) in its pool offering documentation; comply with certain advertising and promotional material requirements; distribute periodic account statements and reports; distribute audited annual financial reports; implement prescribed policies and procedures; and maintain and make accessible prescribed books and records.6 A CTA is a person who, for compensation or profit, advises other persons regarding the value or advisability of transacting in commodity interests.7

Unless exempt from some or all of the CTA regulatory requirements, a CTA must (among other things):

register with the CFTC and become a member of the NFA; distribute a disclosure document to prospective clients containing specified disclosures (including but not limited to risks, conflicts, fees and costs, and performance); implement prescribed policies and procedures; and maintain and make accessible prescribed books and records.8 NFA membership for CPOs and CTAs involves making filings and paying fees. NFA members are also subject to periodic NFA examinations. In addition, natural person associates and their supervisors, and certain principals of CPOs and CTAs must register with the NFA and satisfy certain proficiency requirements that include taking and passing the National Commodity Futures Examination, known as the "Series 3 Exam," submitting fingerprints, participating in periodic ethics and other training, and paying fees.9

Current CPO and CTA Exclusions and Exemptions

Several exemptions from certain of the CPO registration and regulation requirements are currently available, including (among others) where investors in a privately offered pool are deemed not in need of regulatory protection, due to:

their financial or investment sophistication or regulatory status;10 the relatively small size of the pool;11 and/or the limited amount of commodity interest trading in the pool.12 A RIC that would otherwise constitute a pool is currently excluded from the definition of a CPO (rather than exempt from CPO registration and regulation) because the CFTC has previously considered the extensive regulation of such entities by the SEC under the Investment Company Act of 1940 as amended ("1940 Act") to afford sufficient investor protection without additional regulation by the CFTC.13

Several exemptions from certain CTA registration and regulation requirements and exclusions from the definition of CTA are also currently available, including (among others):

where the person is exempt from registration as a CPO and provides commodity trading advice solely to the pools for which the person is exempt;14 where in the past year the person provided advice to a limited number of clients (15 or fewer) and did not hold itself out to the public as a CTA;15 where the advice the person provides is not tailored to an individual customer's account, such as with the provision of a newsletter;16 where the person is registered in another capacity and provides commodity trading advice that is solely incidental to the principal business;17 or where the person is otherwise excluded under the Commodity Exchange Act as amended ("CEA").18 In addition, if a person is registered as an investment adviser ("RIA") with the SEC, it may qualify for a CTA exemption if (1) the person's business does not consist primarily of acting as a CTA, and (2) the person does not provide commodity trading advice to commodity pool that is engaged primarily in commodity interests.19 Alternatively, an RIA may qualify for a CTA exemption if it is providing commodity trading advice to certain qualifying entities such as RICs.20

The CFTC proposes to modify or rescind several of the foregoing CPO and CTA exclusions and exemptions as follows.

Reinstate and Expand on Trading and Marketing Criteria Necessary to Qualify for CFTC Regulation 4.5 Exclusion

In August 2010, the NFA petitioned the CFTC to amend CFTC Regulation 4.5, which currently excludes RICs (among others) from the CPO definition under the CEA.21 The NFA requested that the CFTC place limitations on the blanket exclusion for RICs, thereby requiring RICs with greater than de minimis investments in commodities to register and be regulated as CPOs.

Limitations similar to those proposed by the NFA were in place prior to 2003.

Under CFTC Regulation 4.5 as in effect prior to 2003, a RIC could qualify for the CPO exclusion only if its commodity interest trading above a five-percent threshold was conducted solely for bona fide hedging purposes as defined by CFTC Regulation 1.3(z)(1).22 For commodity interest positions not held for bona fide hedging purposes, the aggregate initial margin and premiums for those positions could not exceed five percent of the liquidation value of the RIC's portfolio after taking into account unrealized profits and unrealized losses on such positions ("five-percent trading test"). Any "in-the-money" amount on commodity options was excluded from the five-percent calculation. In addition, the RIC could not be marketed as a commodity pool or vehicle for trading in commodity interests ("marketing restriction"), but this restriction did not extend to trading in swap and other OTC transactions, structured notes, or other instruments providing indirect exposure to the commodity markets.23

In 2003, the five-percent trading test and marketing restriction were removed; accordingly, CFTC regulation has not limited the amount of...

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