The Commodity Futures Trading Commission (the "CFTC") recently approved amendments to various CFTC regulations relating to registration as a commodity pool operator ("CPO"). Most notably, the CFTC has rescinded the exemption from registration as a CPO provided in Commodity Exchange Act Rule 4.13(a)(4), which exemption did not impose any limitations on a pool's ability to trade futures. Managers who are currently relying upon Rule 4.13(a)(4) will no longer be able to do so as of December 31, 2012.
For many fund managers, the most likely alternative exemption will be under Rule 4.13(a)(3), which provides a full exemption from registration as a CPO for a manager of a fund that meets certain trading limits.
This memorandum will describe the Rule 4.13(a)(3) exemption and common issues that arise for managers as they seek to determine whether they are able to rely upon the exemption. We will be providing additional guidance on the registration process and the exemptions that may be available to the private investment funds advised by a registered CPO in a future memorandum.
A manager claiming an exemption from CPO registration under Rule 4.13(a)(3) is required to operate every fund it advises such that each fund meets (i) trading limitations, (ii) investor suitability requirements and (iii) offering and marketing restrictions.
II. Exemption Discussion
(i) Trading Limitations
A manager claiming an exemption from CPO registration under Rule 4.13(a)(3) is required to operate each fund it advises that is relying on Rule 4.13(a)(3) in accordance with one of the following trading limitations with respect to its commodity positions at all times: (i) the aggregate initial margin and premiums required to establish commodity positions will not exceed 5% of the liquidation value of the fund's portfolio after taking into account unrealized profits and losses on any such positions; or (ii) the aggregate net1 notional value2 of such positions will not exceed 100% of the liquidation value of the fund's portfolio after taking into account unrealized profits and losses on any such positions. Commodity positions for purposes of Rule 4.13(a)(3) include commodity options, certain swaps, certain forex transactions and futures (including security futures). Forwards are generally not considered commodity positions.
Both of the above trading limitations apply to commodity positions whether or not entered into for hedging purposes and both limitations are to be determined at the time the most recent position was established. In addition, the trading limitations are calculated using transactions both in the United States as well as in the rest of the world.
When determining whether a fund complies with the Rule 4.13(a)(3) trading limitations, a manager is required to "look through" any pooled investment vehicles in which the fund is invested. The look through requirement affects funds-of-funds but it also may impact a directly-managed vehicle that has made an investment in a registered or unregistered investment company which invests in commodity interests. The CFTC had previously provided guidance to fund-of-funds managers on the ways in which they could comply with the requirements of Rule 4.13(a)(3). The CFTC has rescinded that guidance and announced that it will be providing new guidance. We will provide an update as soon it is released.
Commodity Options. The premiums paid for commodity options must be included in the 5% calculation but if an option is in-the-money at the time of purchase, the in-the-money amount may be excluded in computing whether the 5% threshold has been met.
Swaps. Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, many types of swaps are considered to be commodity interests, but security-based swaps are not. The CFTC and the SEC have proposed regulations defining the terms "swap" and "security-based swap" but the regulations have not yet been finalized. Based on the proposed regulations, derivative instruments that are tied to a single loan, a single security or a narrow-based index3 will generally be treated as a security-based swap. All other derivative instruments (including certain credit default swaps and total return swaps) would be swaps and would count towards the trading limitation thresholds for purposes of Rule 4.13(a)(3). We will provide additional updates when the definitions have been finalized.
Forex Transactions. Generally, forex transactions (other than forex swaps) will not count towards the Rule 4.13(a)(3) trading limitations, unless the fund is a retail customer.4 A pooled investment vehicle with assets under management of at least $10 million and that is operated by a registered CPO or a CPO relying on Rule 4.13(a)(3) will generally not be treated as a retail customer. If the Fund is a retail customer, for purposes of calculating the 5% threshold, the aggregate initial required minimum security deposit for retail forex transactions is used. When calculating the aggregate net notional value of the positions, the notional value of the retail forex transactions is the value in U.S. dollars at the time of the transactions.
(ii) Investor Suitability
In order for a manager to claim the exemption under Rule 4.13(a)(3), the manager must reasonably believe, at the time of investment, that each investor in the fund is an accredited investor, a non-US person or an investor that meets certain other requirements.
(iii) Offering and Marketing Restrictions
In addition to the trading limitations and investor suitability requirement, the fund must also be offered pursuant to Regulation D of the Securities Act of 1933 and not (i) marketed as a vehicle for trading in the commodity futures or commodity options markets or (ii) marketed to the public in the U.S. The Jumpstart Our Business Startups Act (the "JOBS" Act") instructed the SEC to revise its rules to remove the prohibitions against general solicitation and general advertising in connection with many offers and sales of securities made pursuant to Regulation D. The JOBS Act did not instruct the CFTC to make any similar changes to its regulations.
(iv) Additional Requirements
Any manager that claims an exemption under Rule 4.13(a)(3) will be required to make an initial filing with the NFA and maintain books and records relating to its commodity trading. The Manager will also be subject to any special calls that the CFTC may impose relating to eligibility for, and compliance with, the exemption. In addition, the CFTC has imposed a new requirement that each manager claiming an exemption under Rule 4.13(a)(3) must make an annual filing with the National Futures Association affirming its eligibility to rely on the exemption.
If you have any questions regarding the amendments or the CPO registration process, please contact an attorney in the Investment Management Group at Seward & Kissel. In addition, the amendments can be accessed at www.cftc.gov.
1 The manager may net (i) futures contracts with the same underlying commodity across designated contract markets and foreign boards of trade and (ii) swaps cleared on the same designated clearing organization where appropriate.
2 Notional value is computed by multiplying the number of contracts by the size of the contract, in contract units (taking into account any multiplier specified in the contract), by the current market price per unit. For options on futures, multiply the number of contracts by the size of the contract, adjusted by its delta, in contract units (again taking into account any multiplier specified in the contract), by the strike price per unit.
3 Under the proposed regulations, a narrow-based index would have to meet one of the following conditions: (i) the index has nine or fewer component securities; (ii) a component security comprises more than 30% of the index's weighting; (iii) the five highest weighted component securities in the aggregate comprise more than 60% of the index's weighting; or (iv) the lowest weighted component securities comprising, in the aggregate, 25% of the index's weighting have an aggregate dollar value of average daily trading volume of less than $50,000,000 (or in the case of an index with more than 15 component securities, $30,000,000).
4 Foreign exchange forwards and foreign exchange swaps are proposed by the Department of the Treasury to be excluded from regulation as swaps by its proposed determination in April of 2011 (except for certain reporting, business conduct standards and anti-manipulation purposes).
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