United States: CFTC Proposes Narrowing or Eliminating CPO Registration Exemptions

Recently, the CFTC proposed to modify the criteria for claiming exemption from registering as a Commodity Pool Operator (CPO) under Rule 4.5, upon which many mutual funds rely, and to rescind the exemptions from registration as a CPO under Rules 4.13(a)(3) and (a) (4), upon which private funds rely. The CFTC also called for increased filing and disclosure requirements for CPOs and Commodity Trading Advisors (CTAs) and additional filing requirements for those claiming exemptive relief from registering as a CPO.

Changes to Rule 4.5

Certain persons, including investment companies registered under the Investment Company Act of 1940 (the 1940 Act), may be exempt from registering as a CPO if they meet the criteria set forth under Rule 4.5 of CFTC regulations. Since 2003, Rule 4.5 has required qualifying entities to file a representation stating whether the entity is operated by a person who has claimed an exclusion from the definition of CPO. Currently, Rule 4.5 does not limit qualifying entities' use of commodity futures or commodity options, nor does it restrict qualifying entities from marketing themselves as commodity pools.

The CFTC has proposed that Rule 4.5 be amended to reinstate restrictions similar to those that existed pre- 2003, specifically that entities file a notice of eligibility containing representations that commodity futures or commodity options contracts will be used only for bona fide hedging purposes, or for non-bona fide hedging purposes limited to 5 percent of the liquidation value of the portfolio. In addition, the entity must not market the fund to the public as a commodity pool, or as a vehicle for trading in or otherwise seeking exposure to the commodity futures or commodity options markets. These restrictions would apply only to registered funds.

The proposed change comes in the wake of the CFTC's discovery that certain registered investment companies were offering series of de facto commodity pool interests while claiming exemption under Rule 4.5. The CFTC proposed the aforementioned modifications to stop registered investment companies from offering futures-only investment products without CFTC oversight.

Implications for Registered Funds

If the CFTC's proposal is enacted, in order to take advantage of the Rule 4.5 exemption from registering as a CPO, a registered fund would need to limit its trading of commodity futures or commodity options contracts to bona fide hedging purposes, or to non-bona fide hedging positions (in which case, the registered fund must hold the position directly and limit the aggregate initial margin and premiums required to establish the positions so as not to exceed 5 percent of the liquidation value of the registered fund's portfolio). A registered fund would also need to cease marketing itself as a commodity pool or as a vehicle for trading in, or otherwise providing exposure to, commodity interests. It is unclear how this marketing restriction will fit with SEC prospectus disclosure requirements. Finally, the registered fund would need to confirm its notice of eligibility annually.

Changes to Rules 4.13(a)(3) and (a)(4)

Currently, Rule 4.13(a)(3) exempts certain persons from CPO registration if the interests in the pool are exempt from registration under the Securities Act of 1933 and offered only to Qualified Eligible Persons (QEPs), accredited investors, or knowledgeable employees, and the pool's aggregate initial margin and premiums attributable to commodity interests do not exceed 5 percent of the liquidation value of the pool's portfolio. Rule 4.13(a)(4) applies when the interests in the pool are exempt from registration under the Securities Act of 1933 and the operator reasonably believes that all of the participant are QEPs.

The CFTC proposes to completely rescind the exemptions provided by Rules 4.13(a)(3) and (a) (4). In its proposal, the CFTC stated that because of these provisions, a large group of market participants has evaded regulatory oversight and that continuing to exempt these entities from registering and reporting as CPOs is "outweighed by the [CFTC's] concerns of regulatory arbitrage."

Implications for Private Funds and Private Fund Advisers

Rules 4.13(a)(3) and (a)(4) would be eliminated if the CFTC's proposal is enacted. Therefore, entities that previously claimed an exemption under these rules would be required to register as CPOs, join the National Futures Association (NFA), and fulfill all associated reporting requirements – unless the entity could rely on another exemption. Registering as a CPO can be a relatively lengthy process. CPO reporting requirements include providing disclosure documents to pool participants that would be subject to NFA review and fulfilling certain recordkeeping and periodic and annual reporting requirements.

Finally, investment advisers that currently operate under an exemption from CTA registration on the basis that they provide advice to pools exempt under Rules 4.13(a) (3) and (a)(4) will be required to register as CTAs, join the NFA, and fulfill all associated reporting requirements.

Conclusion

In its proposal, the CFTC expressed awareness that industry participants may find some of the proposed changes to be extremely cost prohibitive, unclear or otherwise undesirable. The CFTC encourages members of the industry to comment on these changes — the comment period will end in late March and the full proposal is available at: http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2011-2437a.pdf.

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