On April 18th, 2012, the Commodity Futures Trading Commission (the "CFTC") and the Securities and Exchange Commission (the "SEC", and together with the CFTC, the "Commissions") adopted joint final rules further defining the terms "swap dealer" ("SD"), "security-based swap dealer" ("SBSD"), "major swap participant" ("MSP"), "major security-based swap participant" ("MSBSP"), and "eligible contract participant" ("ECP") (the "Final Rules").1 The Final Rules generally will become effective 60 days following publication in the Federal Register. Of particular concern to fund managers in connection with the adoption of the Final Rules was a look-through requirement in the ECP definition contained in the Commissions' December 21, 2010 proposed rules (the "Proposed Rules")2 that would have required each participant in a commodity pool to satisfy the ECP definition in order for the commodity pool itself to satisfy the ECP definition for the purpose of the CFTC's retail forex rules. However, as described below, these concerns have substantially been addressed in the Final Rules. The ECP look-through requirement, as modified in final form and as described below, becomes effective on December 31, 2012.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act")3 makes it unlawful for any person that is not an ECP to enter into a swap other than on, or subject to the rules of, a designated contract market.4

Prior to enactment of the Dodd-Frank Act, a commodity pool qualified as an ECP if it had $5 million or more of total assets and was formed and operated by a person subject to regulation under the Commodity Exchange Act (the "CEA") or a foreign equivalent (i.e., including a person exempt from registration as a commodity pool operator ("CPO")). The Dodd-Frank Act amended the ECP definition by providing that, solely for purposes of certain over-the-counter ("OTC") forex transactions specified in CEA sections 2(c)(2)(B) and 2(c)(2)(C) (i.e., retail forex transactions), a commodity pool does not qualify as an ECP if any participant in the pool is not itself an ECP, even though the pool would otherwise meet the definition. This so called "look-through requirement" has been retained in the Final Rules in modified form as described below and imposes certain restrictions on commodity pools with non-ECP participants which engage in OTC forex transactions (each such pool, a "Retail Forex Pool").

For this purpose, CFTC rules impose requirements upon Retail Forex Pools engaging in OTC forex transactions (e.g., only certain U.S. financial institutions, broker-dealers, futures commission merchants and other retail forex dealers5 are permitted to engage in OTC forex transactions with Retail Forex Pools and such permitted counterparties must comply with additional margin and other requirements when engaging in such transactions with Retail Forex Pools).6 As a practical matter, these restrictions would have adversely affected the ability of many pools who have non-ECP participants to engage in OTC forex transactions. In response to concerns expressed by many commenters on this issue, the Commissions have determined to limit the ECP look-through requirement in the Final Rules as described below.

Look-Through Exemption

The Final Rules provide for an exemption from the look-through requirement described above so that a commodity pool (for example a "master fund") may be deemed an ECP for the purpose of the CFTC's retail forex rules, notwithstanding that some participants in such pool do not qualify as an ECP (or if a participant is a pool itself (for example a "feeder fund"), the investors in such participating pool may be exempt from the look-through requirement). A commodity pool will qualify for this exemption7 provided that it:

  1. is not formed for purposes of evading regulation under the CEA or CFTC rules;
  2. has total assets exceeding $10 million; and
  3. is formed and operated by a registered CPO or a CPO exempt from registration under Rule 4.13(a)(3).

As noted, the look-through requirement will not become effective until December 31, 2012, giving those CPOs who are not currently registered some time to register to be able to rely on this exemption if they are unable to rely on Rule 4.13(a)(3) with respect to the operation of a pool. The Commissions note that the obligation to determine whether the parties to retail forex transactions are ECPs is imposed on the CPOs of commodity pools as well as the counterparties seeking to enter into retail forex transactions with commodity pools, and that representations may be relied upon in making such a determination, unless a reasonable person knows or should know to question the accuracy of such representations.8 Note that a CPO located outside of the United States who operates a pool containing no U.S. participants will be considered an ECP regardless of the ECP status of its participants. In general, however, the Commissions have not addressed cross-border issues in the Final Rules which are to be addressed in a separate release in the future.

Fund of Funds and Other Considerations

There are also other important clarifications in the Final Rules, including, among others: (i) including SDs, SBSDs, MSPs and MSBSPs, irrespective of whether they are registered as such, as ECPs;9 (ii) requiring a commodity pool to have total assets exceeding $5 million and to be formed and operated by a person subject to regulation under the CEA or a foreign equivalent to qualify as an ECP10 (i.e., prohibiting a commodity pool from relying on the tests applicable to other entities: (a) total assets of $10 million or (b) a net worth of at least $1 million if entering into transactions to manage risk associated with an asset or liability owned or incurred or reasonably likely to be owned or incurred by the entity in the conduct of the entity's business); and (iii) stating that a fund of funds ("FOF") which uses OTC forex transactions solely to hedge the currency risk related to the currency in which the underlying funds accept investments and the currency in which the FOF accepts investments, will not be deemed to have been structured to evade these rules.11

The text of the Final Rules exceeds 600 pages, and it should be noted that this memorandum principally focuses on the ECP related issues. We will continue to monitor and report on developments in this area.

Footnotes

1 http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister041812b.pdf

2 See 75 Fed. Reg. 80174 (December 21, 2010).

3 See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, 124 Stat. 1376 (2010).

4 See Section 723(a)(2) of the Dodd-Frank Act.

5 See CEA Section 2(c)(2)(B)(i)(II).

6 See 75 Fed. Reg. 55410 (September 21, 2010).

7 See CFTC Regulation §1.3(m)(8).

8 See Final Rules, p. 218.

9 See CFTC Regulation §§1.3(m)(1)-(4).

10 See CFTC Regulation §1.3(m)(6).

11 See Final Rules, p. 216.

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.