Ireland: Proposal to Rescind CFTC Registration Exemptions Will Affect Many Hedge Funds and Other Private Investment Funds

The Commodity Futures Trading Commission ("CFTC") on 26 January 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, including hedge funds.

The CFTC proposes to:

• rescind registration exemptions available for commodity pool operators ("CPOs") offering commodity pools to sophisticated and creditworthy investors under CFTC Regulations 4.13(a)(3) and 4.13(a)(4);
• require CPOs and commodity trading advisors ("CTAs") that are registered solely with the CFTC to file certain new reports regarding their commodity trading activities; and
• amend the risk disclosures included in CPO and CTA documents to describe certain risks of swap transactions. 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. Some elements of the proposals are intended to create CFTC regulation corresponding 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 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"). 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-US 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");²
• 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.

A CTA is a person who, for compensation or profit, advises other persons regarding the value or advisability of transacting in commodity interests. 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.

NFA membership for CPOs and CTAs involves making filings and paying fees. NFA members are also subject to periodic NFA inspections. 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.³

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;
• the relatively small size of the pool; and/or
• the limited amount of commodity interest trading in the pool.

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;
• 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;⁴
• the advice the person provides is not tailored to an individual customer's account, such as with the provision of a newsletter;
• the person is registered in another capacity and provides commodity trading advice that is solely incidental to the principal business;⁵ or
• the person is otherwise excluded under the Commodity Exchange Act as amended ("CEA").

In addition, if a person is registered as an investment adviser with the SEC ("RIA"), 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 any commodity pool that is engaged primarily in trading commodity interests. Alternatively, an RIA may qualify for a CTA exemption if it is providing commodity trading advice to certain qualifying entities such as US registered investment companies.

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

Rescission of Registration Exemptions for CPOs

The CFTC is proposing to rescind the exemptions from registration available to CPOs under CFTC Regulations 4.13(a)(3) and (a)(4). Under the current regulations, a person is exempt from registration as a CPO with respect to a pool if interests in the pool are exempt from registration under US Securities Act of 1933, as amended, and are not marketed to the public in the United States, and where:

• the pool's use of commodity interests is very limited,⁶ and the interests are offered only to accredited investors, knowledgeable employees, and members of certain categories of "qualified eligible persons" ("QEPs") defined in CFTC Regulation 4.7; or
• the pool's use of commodity interests is not limited but the person reasonably believes that the pool participants are all members of certain categories of QEPs.⁷

The Proposing Release notes that the current exemptions, which were adopted in 2003, have permitted a large group of market participants to fall outside the oversight of regulators, and states that "continuing to grant an exemption from registration and reporting obligations for these market participants is outweighed by the [CFTC's] concerns of regulatory arbitrage." The Proposing Release also states that eliminating the exemptions under Regulations 4.13(a)(3) and (a)(4) would be analogous to the Dodd-Frank mandate that the SEC require advisers to certain private investment funds to register with the SEC as investment advisers, and is in line with one of the primary purposes of Dodd- Frank —"to promote transparency with respect to the activities of the financial markets."

Many sponsors and advisers to pools that would otherwise be required to register with the CFTC as CPOs and/or CTAs rely on these exemptions from registration. If adopted, this proposal would mean that the sponsors of such private pools would be required either to claim a different exemption from registration as a CPO, if available,⁸ or to register with the CFTC and become subject to the disclosure, reporting, recordkeeping, advertising, and compliance requirements imposed under the CFTC's regulatory scheme. If required to register, however, many sponsors and advisers to pools could claim exemptions available to registered CPOs and CTAs under CFTC Regulation 4.7 from certain disclosure, reporting, and recordkeeping requirements.

Among other things, the CFTC is seeking comment on this proposal regarding: (1) the time that would be necessary for compliance with the proposal; and (2) whether there are persons who should be exempted from compliance with the proposed revisions.

Require Solely-Registered CPOs and CTAs to File New Reports Regarding Commodity Trading Activities

Citing a lack of transparency and enhanced concerns regarding systemic market stability, the CFTC has proposed new CFTC Regulation 4.27, requiring registered CPOs and CTAs to file Forms CPO-PQR and CTA-PR, respectively. The CFTC plans for the new forms to parallel the proposed Form PFF⁹ (a new reporting form to be used by RIAs or by firms dually registered with the SEC and CFTC) and to allow the CFTC to provide systemic risk information to the Financial Stability Oversight Counsel ("FSOC") and other regulators. Understanding that such disclosure contains valuable and non-public information, the CFTC has examined issues of confidentially regarding these disclosures, and determined that the proprietary information provided by these forms would not be subject to release under the US Freedom of Information Act.

The CFTC has also attempted to address the burden of regulatory compliance by balancing its concerns regarding systemic risk with the cost of compliance obligations. As such, the CFTC has proposed a tiered system of regulation, with more frequent and detailed disclosures required for CPOs and CTAs with over $150 million in assets under management ("AUM"), and additional disclosures for CPOs and CTAs with over $1 billion in AUM, as detailed below.

Schedule A of Form CPO-PQR is composed of two parts. Part One requires the disclosure of general information required by the NFA's current pool quarterly reports, including the CPO's name and AUM. Part Two requires disclosure of information regarding each of the CPO's pools, including position information for positions comprising more than five percent of the pool's net asset value, monthly and quarterly performance, and redemption terms and restrictions. A separate Part Two must be filed for each pool advised by the CPO.

Schedule B of Form CPO-PQR requires more detailed disclosure concerning the pools operated by the CPO, including investment strategy, borrowing by geographic area, and credit counterparty exposure. Schedule C of Form CPOPQR is composed of two parts and is required only for the largest CPOs. Part One requires aggregate information concerning the pools advised by the CPO, including the market value of assets invested in different types of securities and derivatives. Part Two requires similar disclosure for each individual pool with a net asset value of $500 million or more advised by the CPO, as well as additional disclosure including collateral practices of the pool, investor composition, and liquidity information.

Similar to Schedule A of Form CPO-PQR, Schedule A of Form CTA-PR requires general disclosure, including the total assets directed by the CTA and total pool assets directed by the CTA. Schedule B of Form CTA-PR requires more detailed disclosure, including positions, performance, and trading strategy for each of the CTA's trading programs as well as the pools advised by each program and the percentage of each pool's assets that are directed by the CTA.

New Risk Disclosure Statement for CPOs and CTAs

In light of Dodd-Frank's expansion of the CFTC's authority to regulate OTC swaps, the CFTC is proposing new components of the "Risk Disclosure Statements" for CPOs and CTAs to describe risks attendant to swap transactions. The proposed changes would amend CFTC Regulations 4.24 and 4.34 to require standard risk disclosures, at the beginning of a CPO or CTA disclosure document, that all swap transactions present market, credit, funding, and operational risks, and that certain swap transactions also present liquidity risk and heightened risk of loss. The disclosures would also note that swaps "may only be modified or terminated only by mutual consent of the original parties." The CFTC is seeking comment on whether these disclosures accurately represent the risks faced by CPO pool participants and CTA clients.

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Given the expanded jurisdiction that Dodd-Frank has granted the CFTC and the general regulatory tenor post-2008, the CFTC appears intent to scale back CPO and CTA exclusions and exemptions. However, there is ample room in the CFTC's Proposing Release for public and private fund industry input— drawing on regulatory and operational expertise—to ensure that the proposed changes provide sensible and harmonised regulation, avoid duplicative, conflicting, and unnecessary regulation, provide sufficient lead time for compliance, and exempt and grandfather logical participants.

The public comment period will end on 12 April 2011. Market participants that could be affected by the Proposing Release should consider submitting a comment letter.

Footnotes

1. Commodity Pool Operators and Commodity Trading Advisors: Amendments to Compliance Obligations, 76 FR 7976 (Feb. 11, 2011) ("Proposing Release"). On 27 January 2011, Dechert LLP issued a NewsFlash client alert regarding the proposed rulemaking available at http://www.dechert.com/emailings/newsflash/fs-nf-01-27-11.html.

2. The NFA is the registered self-regulatory organization for the US futures industry.

3. For a more detailed description of the registration requirements for CPOs, CTAs and their respective principals and associated persons, refer to the NFA website, available at http://www.nfa.futures.org.

4. A CTA that has its principal place of business outside the United States need only count US clients.

5. For example, where the person is a cash market dealer in a commodity and provides commodity trading advice solely incidental to the conduct of that cash market business

6. In this instance, "very limited" means either: (a) that the pool's aggregate initial margin and premiums attributable to commodity options and commodity futures, respectively, do not exceed five percent of the liquidation value of the pool's portfolio after taking into account unrealized profits and unrealized losses on any such positions it has entered into, provided that, in the case of an option that is in-the-money at the time of purchase, the in-the-money amount may be excluded in computing such five percent; or (b) that the aggregate net notional value of such positions does not exceed 100 percent of the liquidation value of the pool's portfolio after taking into account unrealized profits and unrealized losses on any such positions it has entered into. Both tests do not differentiate as to whether the positions are held for bona fide hedging purposes or otherwise. 17 C.F.R. § 4.13(a)(3)(ii).

7. "Non-United States Persons" are eligible to participate in pools without limit because Non-United States Persons are included as QEPs under § 4.7(a)(2)(xi).

8. One exemption which might be applicable is CFTC Regulation 30.4, which exempts from CPO registration the sponsors of non-US investment pools, provided that (i) the pool does not transact future contracts or options on any US futures markets, (ii) the pool is exempt from registration under the US Investment Company Act of 1940 and the pool's securities are exempt from registration under the US Securities Act of 1933; and (iii) no more than 10 per cent of the participants in or values of the assets of the pool are held by U.S. investors.

A second exemption which may be available is CFTC Regulation 30.5, which exempts from CPO registration the sponsors of non-US investment pools, provided that, among other things, (i) the pool does not transact future contracts or options on any US futures markets; (ii) the sponsor files a petition with the NFA representing that it is located outside the United States and does not engage in trading on U.S. futures markets for its U.S. clients and agrees to submit to U.S. jurisdiction; and (iii) the sponsor enters into a written agreement appointing a U.S. entity as agent for service of process.

9. Form PF will require private investment funds to disclose certain financial information for use by FSOC (defined below) in monitoring systemic risk. Form PF will be required only for RIAs, although CPOs and CTAs registered with both the SEC and the CFTC will also need to complete this form. Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors on Form PF, SEC Rel. No. IA-3145 (Jan. 26, 2011) (proposed rule), available at http://www.sec.gov/rules/proposed/2011/ia-3145.pdf.

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