UK: NFA Petitions for Rulemaking to Amend Regulation Excluding Registered Investment Companies from CFTC Regulation

Last Updated: 6 September 2010
Article by M. Holland West, Matthew K. Kerfoot and Audrey Wagner

The National Futures Association ("NFA")1 has petitioned the U.S. Commodity Futures Trading Commission ("CFTC") to amend CFTC Regulation 4.5, which currently excludes (among others) registered investment companies ("RICs") from the "commodity pool operator" ("CPO") definition under the U.S. Commodity Exchange Act, as amended ("CEA").2 The NFA has requested that the CFTC place limitations on the blanket exclusion, thereby requiring RICs with greater than de minimus investments in commodities to register and be regulated as CPOs. Limitations similar to those the NFA has requested were in place prior to 2003. The NFA considers these requested changes necessary to protect investors in RICs that provide meaningful exposure to the commodity markets.

Background on CPO Registration and Regulation

A CPO is a person that sponsors, solicits participation in, or operates a collective investment vehicle ("pool") that trades exchange-traded futures contracts or options thereon ("commodity interests").3 Unless excluded from the CPO definition or exempted from some or all of the CPO regulatory requirements, a CPO must (among other things): (1) register with the CFTC through the NFA; (2) become a member of the NFA; (3) include specified disclosures (regarding risks, conflicts, fees and costs, and performance) in its pool offering documentation; (4) comply with certain advertising and promotional material requirements; (5) distribute periodic account statements and reports; (6) distribute audited financial reports; and (7) maintain, retain, and make accessible certain books and records.4 In addition, natural person associates of the CPO and their supervisors 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".5

Available CPO Exemptions and Exclusions

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: (1) their financial or investment sophistication or regulatory status;6 (2) the relatively small size of the pool;7 and/or (3) the limited amount of commodity interest trading in the pool.8 A RIC that would otherwise constitute a pool is currently excluded from the definition of CPO (rather than exempt from CPO registration and regulation) because the CFTC has considered the extensive operational regulation of such entities by the U.S. Securities and Exchange Commission ("SEC") under the U.S. Investment Company Act of 1940, as amended ("1940 Act"), to afford sufficient investor protection without additional regulation by the CFTC.9

Pre-2003 Restrictions on Certain RICs

Currently, CFTC regulation does not limit the amount of commodity interest trading a RIC may conduct in order to qualify for the CPO exclusion.10 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).11 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-themoney" 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 ("no marketing restriction").12

NFA Petition for CPO Rulemaking

In its petition to the CFTC, the NFA requested that "[RICs] that engage in more than a de minimis amount of futures trading and that are offered ... or ... marketed to retail customers [be] subject to the appropriate regulatory requirements and oversight by regulatory bodies with primary expertise in commodity futures" through CPO registration. The NFA is concerned that the "otherwise regulated nature" of RICs sold to retail investors or the public generally may not provide adequate investor protection in instances where the RIC is significantly invested in, or providing exposure to, commodity interests.13 The NFA states that some RICs have been able to create and market de facto traditional commodity pools to retail investors (some of whom are unsophisticated in commodity investments) outside of CFTC regulation, oversight, and customer protection. Additionally, the NFA expressed concern that CPOs of public commodity pools might avail themselves of the alternative RIC structures described below, to circumvent registration and regulation. To address these concerns, the NFA has requested that the CFTC, with respect to RICs, reinstitute the five percent trading test and expand the no marketing restriction that applied to the CFTC Regulation 4.5 exclusion prior to 2003 (as discussed above).14 The proposed expanded "no marketing restriction" would prevent a RIC from being marketed as a pool or otherwise as a vehicle for trading in "or otherwise seeking investment exposure to" commodity interests.15

Finally, the NFA recognized that the CFTC has granted CPO operational exemptions to certain exchange-traded funds ("ETFs") that are commodity pools organized as statutory trusts. The NFA requested that the CFTC determine if it was still appropriate to grant similar or other exemptions to ETFs and other public pools and listed pools operating as RICs.

Potential Effect on Certain RICs

Commodity-focused RICs have been a fixture in the asset management space for many years. Fund companies had been able to comply with the pre-2003 restriction on substantial investments in commodity interests because RICs had invested in part in securities or derivatives linked (directly or indirectly) to commodity interests, rather than in the actual commodity interest contracts. Fund companies had been able to comply with the earlier no marketing restriction because the RICs were not marketed as commodity pools or vehicles for trading commodity interests. Instead, they were marketed as providing exposure to commodity interests indirectly through commoditylinked securities and derivatives, as well as commodity interests. Many such RICs are structured differently than public commodity pools that trade commodity interests directly—instead trading commodity interests and managed futures trading programs indirectly through their ownership of subsidiaries established for tax and mutual fund regulatory purposes.

The NFA's proposed expansion of the no marketing restriction to include any RIC providing exposure to commodity interests has the potential to affect every commodity-focused RIC in the industry. All RICs that provide commodity exposure through securities or exchanged-traded and over-the-counter derivatives or through unregulated subsidiaries engaged in such trading would no longer be able to rely on the CFTC Regulation 4.5 exclusion from CPO registration and regulation. Such RICs and their principals and associated persons would likely need to register with the CFTC and NFA and be subject to the full panoply of applicable marketing and operating laws and regulations, including the disclosure reporting, recordkeeping, advertising and promotional material, and other operating and compliance restrictions and requirements.

To date, the CFTC has not decided whether to submit the NFA's proposal for public comment. If the CFTC decides to act on the NFA's petition, it will offer a proposed rule amendment for public comment, in which case interested clients, industry associations, and other regulators (such as the SEC) will be able to debate the merits and need for such additional and some duplicative requirements applicable to certain RICs. We will continue to monitor this development.


1 The NFA is the registered self-regulatory organization for the U.S. futures industry. 7 U.S.C. § 17.

2 Letter from Thomas W. Sexton, III, Senior Vice President and General Counsel, NFA, to David Stawick, Office of the Secretariat, CFTC (June 29, 2010), available at http://www.nfa. =2491. On August 18, 2009, in a revised letter, the NFA clarified that the rule amendment should only apply to RICs and not to the other entities eligible for exclusion under CFTC Regulation 4.5. Letter from Thomas W. Sexton, III, Senior Vice President and General Counsel, NFA, to David Stawick, Office of the Secretariat, CFTC (August 18, 2010), available at asp?ArticleID=3630 [hereinafter, "NFA Letter"].

3 7 U.S.C. § 1a(5); 17 C.F.R. §§ 4.10(d)(1), 1.3(yy).

4 17 C.F.R. §§ 4.20–4.26.

5 For a more detailed description of the registration requirements for CPOs and their principals and associated persons, refer to the NFA website, available at

6 17 C.F.R. § 4.13(a)(4).

7 17 C.F.R. § 4.13(a)(2).

8 17 C.F.R. § 4.13(a)(3). See also 17 C.F.R. § 4.12, applicable to both publicly and privately offered pools.

9 17 C.F.R. § 4.5. The antifraud provisions of the CEA (7 U.S.C. § 4(o)) do not apply to excluded persons, but do apply to exempted persons.

10 However, a RIC's investment in commodities is limited by Section 3(a) of the 1940 Act and Subchapter M of the U.S. Internal Revenue Code of 1986, as amended ("Code").

11 17 C.F.R. § 1.3(z)(1). Since adopting Regulation 1.3(z)(1) in 1977, the CFTC has clarified, interpreted, and reinterpreted what it means to be engaged in bona fide hedging. See Background on Position Limits and the Hedge Exemption, Statement of Dan M. Berkovitz, General Counsel, CFTC (Jan. 14, 2010), available at

12 See generally Additional Registration and Other Regulatory Relief for Commodity Pool Operators and Commodity Trading Advisors; Past Performance Issues, 68 Fed. Reg. 47221 (Aug. 8, 2003).

13 Under Section 851(b)(2) of the Code, in order to be a RIC, a RIC must derive at least 90% of its gross income from sources that produce "qualifying income." Commodities are not a source of qualifying income, thus limiting a RIC's investment to a maximum of 10% of its gross income. However, the U.S. Internal Revenue Service has been willing to issue private letter rulings stating that income arising from investments in controlled foreign corporations ("CFCs") that invest in commodities and commodity-linked investments constitutes qualifying income under Subchapter M of the Code. In order for a RIC to take advantage of this characterization but still be considered diversified under Subchapter M, only 25% of the RIC's total assets may be invested in its CFC. The NFA Letter interprets some RIC prospectuses to indicate that the respective RIC's investment in its CFC is meant to use leverage to achieve a managed futures exposure equal to the full net asset value of the RIC instead of an exposure of only 25% or less. NFA Letter, supra note 2.

14 NFA Letter, supra note 2.

15 Id.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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