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US Regulatory Brief: CFTC's New Rules Applicable to CPOs and CTAs

The Commodity Futures Trading Commission has adopted new rules that provide regulatory relief to certain CPOs and CTAs. Lawrence T. Eckert of Schulte Roth & Zabel LLP explains the final rules in greater detail.

The rules discussed below are effective immediately and supersede the temporary no-action relief provided by the Commission pending final rules.  Persons that have filed notices claiming no-action relief generally need not file anything additional in order to rely on the final rules.  Certain additional disclosures to investors may be necessary, however.

1. New Registration Exemptions Available to CPOs and CTAs

A. Background

Historically, the "operator" of a collective investment vehicle that invested, to any extent, in futures or commodity options ("commodity interests"), had been required to register with the Commodity Futures Trading Commission ('CFTC') as a commodity pool operator ('CPO').  Similarly, absent an exemption, a person that provided commodity interest trading advice to a collective investment vehicle was required to register as a commodity trading adviser ('CTA').  The registration process requires that certain principals and persons associated with the CPO or CTA undergo a background check, and also requires that those people involved in marketing activities or supervision thereof pass the "Series 3" license examination.  Additionally, persons registered with the CFTC are required to comply with the panoply of regulations adopted by the Commission.  Operators of, and advisers to, hedge funds typically have relied on relief from the more burdensome of the Commission's disclosure, reporting and recordkeeping requirements under Section 4.7 of the CFTC's regulations ("Rule 4.7").  Rule 4.7 provides an exemption from such requirements to the operator of a fund comprised solely of participants that are deemed "qualified eligible persons" ("QEPs") under the rule, by virtue of such participants having met certain sophistication or other specified criteria.  Rule 4.7 provides a similar exemption for CTAs that provide advice to QEPs.

CPOs and CTAs that rely on an exemption under Rule 4.7, nonetheless, are required to register with the Commission.  The final rules codify certain new exemptions for CPOs and CTAs that go beyond the relief provided in Rule 4.7, by exempting certain persons from registration with the Commission, rather than simply providing an exemption from certain of the requirements applicable to registered persons.  The exemptions are independent of one another and the CPO exemptions are available on a fund-by-fund basis.

     B. Two New CPO Registration Exemptions:

1. Rule 4.13(a)(4) - No Limitation on the use of Commodity Interests where a Fund's Participants are Certain Highly Sophisticated Persons.

Rule 4.13(a)(4) is, generally speaking,  the less restrictive of the two new CPO registration exemptions.  Under this rule, the operator of a fund is exempt from CPO registration and is permitted to use commodity interests without any limitation if, among other things, the operator of the fund has a reasonable belief that each of the fund's participants is one of the following:

* A natural person (including a person's self directed employee benefit plan) that is a "qualified eligible person" as defined in CFTC Rule 4.7(a)(2).  This rule includes, among others, the following:

  • "Qualified purchasers," as defined under Securities and Exchange Commission ("SEC") rules.

  • "Knowledgeable employees" as defined under SEC rules.

  • Other employees who (i) are "accredited investors," as defined under SEC rules, and (ii) have been engaged in providing commodity interest, securities or other financial services for at least 24 months.

  • Non-U.S. persons as defined under CFTC rules.

  • Certain industry professionals and principals.

  • Certain family members of, and persons who received their interest by gift or bequest from, principals and employees.

  • Note:  An individual that qualifies as a QEP solely by virtue of such person's financial status (e.g., an accredited investor with $2 million in investments), is not an eligible natural-person investor in a fund operated under this exemption, absent satisfying one of the other eligibility requirements above.

* A non-natural person that is either a QEP under CFTC rules or an "accredited investor" under SEC rules.

                   Interests in a fund operated under Rule 4.13(a)(4) must be exempt from registration under the Securities Act of 1933 and must be offered and sold without marketing to the public in the United States. 

                   Based upon the criteria noted above, the operator of a hedge fund that complies with the criteria under Section 3(c)(7) of the Investment Company Act of 1940 would generally be eligible to take advantage of this exemption with respect to such fund.

            2. Rule 4.13(a)(3) - Use of Commodity Interests Limited

            An exemption under new Rule 4.13(a)(3) may be available to CPOs in certain circumstances where the
            Rule 4.13(a)(4) exemption, discussed above, is unavailable due to the ineligibility of certain investors in 
            the fund.  The financial threshold for investor eligibility is generally lower under Rule 4.13(a)(3) than 
            under 4.13(a)(4), but fund operators that rely on this exemption with respect to a fund are subject to certain
            limitations on their use of commodity interests.
             Specifically, the operator of a hedge fund can avail itself of the exemption under CFTC Rule 4.13 (a) (3) 
             with respect to a fund, if, among other things:

* The CPO has a reasonable belief that each of the participants in the fund is either:  (1) an accredited investor, as defined under SEC rules; (2) a trust that is not an accredited investor but was formed by an accredited investor for a family member; (3) a knowledgeable employee, as defined under SEC rules; or (4) one of certain specified industry professionals, principals, employees or family members thereof;

* At all times, either of the following tests are met:

  • the aggregate initial margin and premiums required to establish commodity interest positions does not exceed five percent of the liquidation value of the fund's portfolio; or

  • the aggregate net notional value of the fund's commodity interest positions does not exceed 100% of the fund's liquidation value;

* Interests in the fund are exempt from registration under the Securities Act of 1933 and are offered and sold without marketing to the public in the United States; and

* The fund is not marketed as a vehicle for trading in commodity futures or commodity options.

It should be noted that non-U.S. persons are not included in the list of eligible participants under this exemption.  Accordingly, a non-U.S. fund that wishes to rely on the exemption would be required to have a reasonable belief that each of its fund participants (whether U.S. or non-U.S.) is an accredited investor or otherwise meets one of the eligibility criteria described above.

3. Application of Exemptions to Funds of Funds.

The final rules provide some, if not complete, clarification regarding the application of the Commission's new exemptions in the context of funds of funds; i.e. funds that invest in commodity interests indirectly through investments in other investment vehicles ("investee funds").  The rules make clear that CPOs of funds of funds that wish to rely on the exemption under CFTC Rule 4.13(a)(4) may do so without regard to the trading engaged in by investee funds.  This is because Rule 4.13(a)(4) does not place any limits on the level of commodity interest trading that a CPO may engage in.  CPOs that rely on the exemption under 4.13(a)(3), however, are subject to certain commodity interest trading limitations.  In this regard, the Commission adopted a new Appendix to its rules concerning CPOs and CTAs, which provides an explanation as to how the exemption is intended to apply under various fact situations.  The Commission indicated that the Appendix reflects the general principle that relief under Rule 4.13(a)(3) should be available to the CPO of a fund of funds where:

* CPO of each investee fund has either claimed relief under Rule 4.13(a)(3) or, nonetheless, complies with the trading limitations set forth in the rule (i.e., it is eligible to claim the relief).

* The CPO of the fund of funds has actual knowledge of the trading and commodity interest positions of the investee funds.  In such a case it may aggregate the commodity interest positions across the investee funds to determine compliance with the rule's trading limitations.

* The fund of funds does not trade commodity interests directly, and the CPO thereof has allocated no more than 50% of the fund's assets to investee funds that trade commodity interests.

* A fund of funds invests directly in commodity interests in addition to allocating assets to investee funds and treats such directly traded portion of the fund as a "separate pool," subject to the trading limitations set forth in the rule.

              The Commission noted that persons whose situations do not fit within the scenarios set forth in the Appendix should contact Commission staff to discuss the applicability of the rule to their particular facts.

           4. Requirements to Claim An Exemption.

               In order to take advantage of either exemption from registration discussed above, a notice claiming the exemption must generally be filed with the National Futures Association with respect to each fund that will be operated pursuant to the exemption.  The notice provides certain contact information with respect to the CPO and a representation that the fund will be operated in accordance with the criteria of the relevant exemption.  Additionally, the exempt CPO must provide each prospective fund participant with (i) a statement that the CPO is exempt from registration with the CFTC and that, therefore, it need not provide participants with a CFTC disclosure document and certified annual report; and (ii) a description of the criteria pursuant to which the CPO qualifies for the exemption.  The notice must be filed, and the disclosure provided, no later than the time that a subscription document is delivered to a prospective participant in the pool. 

                Further, where a CPO is registered with the Commission and intends to withdraw from registration in order to take advantage of one or both of the new exemptions (or where a CPO remains registered, but elects to operate an existing fund under one of the exemptions), the CPO must notify its participants in writing that it intends to withdraw from registration and claim the exemption, and it must provide each existing participant with a right to redeem its interest in the fund prior to filing a notice of exemption from registration.  This right of redemption may present concerns for managers that operate funds that subject investors to a "lock-up" period and for private equity fund managers that have registered as CPOs.  Any special facts and circumstances would have to be considered by the CFTC's staff on a case-by-case basis.

            5. Continuing Obligations of CPOs.

Notwithstanding that the operator of a fund may claim an exemption from registration as a CPO pursuant to one or both of the new exemptions, a fund that trades in commodity interests is, nonetheless, deemed to be a commodity "pool" for CFTC purposes and the fund's operator is a CPO. As such, those CFTC rules that apply to all CPOs (whether registered or not) continue to apply to CPOs that have claimed a registration exemption.  These rules include, for example, the CFTC's prohibition against fraud.  Additionally, the final rules provide that a person that has claimed an exemption from CPO registration must do the following:

* Maintain books and records in connection with its CPO activities for five years and keep such books and records readily accessible for two years and available for inspection by the Commission, the US Department of Justice or another appropriate regulatory agency;

* Submit to such special deals as the Commission may make to demonstrate eligibility for, and compliance with, the relevant exemption criteria; and
* If the CPO distributes an Annual Report to fund participants, such report must be presented and computed in accordance with generally accepted accounting principles.

C. CTA Registration Exemptions.

1. Rule 4.14(a)(8) - A Parallel Exemption for CTAs.

The final rules provide a registration exemption for CTAs that is similar to that described above with respect to CPOs.  CFTC Rule 4.14(a)(8), as amended, provides an exemption from registration for CTAs that advise, among other persons, a CPO that has claimed an exemption from registration under either or both of Rule 4.13(a)(3) or Rule 4.13(a)(4).  Like the CPO exemptions, a CTA that wishes to claim an exemption from CTA registration under this rule must file a notice with the National Futures Association claiming the exemption and comply with certain continuing regulatory obligations, including the maintenance of books and records and the submission to any special calls by the Commission to demonstrate compliance with the exemption.  
It is worth noting that the CTA registration exemption under Rule 4.14(a)(8) is only available to CTAs that advise CPOs of funds and certain other specified persons .  It is not generally available to a CTA that advises managed accounts, even if the account would be an eligible participant if it invested in a fund operated pursuant to an exemption under Rule 4.13(a)(3) or (a)(4).   However, in light of the additional relief described below, this exclusion may prove to be of little concern.

2. Expansion of Section 4m(1) under the Commodity Exchange Act - Counting a Fund as a Single Client.

Section 4m(1) under the Commodity Exchange Act, as amended ("CEA") provides a statutory exemption from CTA registration, similar to the investment adviser registration exemption under Section 203(b)(3) of the Investment Adviser's Act of 1940 ("Advisers Act").  Specifically, Section 4m(1) provides, in pertinent part, that a CTA is not required to register as such if (i) during the preceding 12 months it has not provided commodity trading advice to more than 15 persons, and (ii) it does not hold itself out generally to the public as a CTA.  Historically, the Commission has "looked through" a fund and counted all of a fund's investors when calculating the number of clients a CTA had advised in the preceding 12 months.  The Commission has now adopted a new regulation, in effect codifying an interpretation of the statutory exemption that is consistent with the SEC's interpretations under the Advisers Act.  Thus, funds and certain other entities will now generally be counted as a single person for purposes of the fifteen person restriction.   The Commission also clarified that a CTA will not be deemed to be "holding itself out" to the public based solely upon its participation in a private placement of a hedge fund under the Securities Act of 1933.

II.  Relief for Registered Investment Companies and Other Regulated Entities

CFTC Rule 4.5 provides an exclusion from the definition of the term commodity pool operator (and thus from registration) for certain persons that are subject to a regulatory scheme, other than that administered by the CFTC, and that operate a "qualifying entity" as defined in the rule.  Qualifying entities include, generally, registered investment companies, insurance company separate accounts, certain trusts and custodial accounts established and maintained by banks and trust companies and certain pension plans that are subject to ERISA and that are operated by an employer, trustee or fiduciary.   Prior to the final rules, persons that relied on the exclusion under Rule 4.5 were subject to certain limitations on their commodity interest trading that was engaged in for other than "bona-fide hedging" purposes.   The final rules have eliminated this limitation.  The final rules also have eliminated a previous prohibition on marketing participations to the public as a commodity pool.  Accordingly, registered investment companies and other qualifying entities under Rule 4.5 may now market their products and utilize commodity interests without any restriction under CFTC rules.

In light of the changes to Rule 4.5, noted above, the final rules require that disclosure be provided to participants indicating that the qualifying entity has claimed exclusion from the CPO definition and that, therefore, the entity is not subject to CPO registration and regulation under the CEA.   Such disclosure would not be necessary if an entity continues to comply with the Commission's previously prescribed trading limitations.  Further, the rule continues to require that a notice of eligibility claiming the exclusion be filed with the National Futures Association and that the qualifying entity agree to submit to any special calls that the Commission may make to require the entity to demonstrate compliance with the rule.

III. Other New Rules.

In addition to the new exemptions and the expansion of existing exemptions and exclusions described above, the Commission has adopted and/or amended certain of its rules applicable to CPOs that continue to maintain their registrations.

A. Electronic Distribution of Account Statements and Annual Reports.

Registered CPOs that are not exempt under one of the new rules discussed above, whether operating under Rule 4.7 or otherwise, are required to provide certain periodic Account Statements and Annual Reports (collectively, "Reports") to participants in their funds.  The Commission has adopted a new rule that permits a CPO to distribute Reports to its participants by electronic means.  The rule requires that, prior to the transmission of any such document, the CPO disclose to its participants that it intends to distribute the document electronically absent an objection from the participant, which objection must be made no later than 10 business days following the participant's receipt of the disclosure.  A CPO that distributes Reports by electronic means must maintain a manually signed copy of such Report.  Similarly, a Report is permitted to contain a facsimile signature, provided that the CPO maintains the manually signed Report from which the facsimile was made and , provided further, that the Annual Report filed with the National Futures Association is manually signed.

B. Elimination of Duplicative Account Statement and Annual Repot Delivery Requirement for Master/Feeder Funds

As noted above, registered CPOs generally must provide certain Reports to their participants.  In the case of a participant that is another fund, these Reports are provided to the CPO of such fund.  In the master/feeder fund context, this rule has typically resulted in the CPO of the master fund providing Reports to itself, as the CPO of, or an affiliate of the CPO of, the feeder funds.  Commission staff have typically provided relief to CPOs that fall within this situation on a case-by-case basis.  The final rules codify the relief previously provided by CFTC staff by no-action letter, thus obviating the need for requests for relief on an individual basis

C. Conforming Signature Requirements

The CFTC has adopted a "universal standard" with respect to the appropriate signatories for documents that must be signed by a CPO or CTA under its rules.  In the past, each CFTC rule containing a signature requirement included a laundry list of appropriate signatories.  The final rules eliminate these lists and amend the appropriate rules to require that documents be manually signed by a "representative duly authorized to bind" the entity.
                                          *     *     *     *     *
The final rules are the culmination of months of review by the CFTC of their CPO and CTA regulations as part of the Commission's ongoing effort to modernize its regulations.  The rules represent a long-awaited and far-reaching change in the regulatory landscape as it applies to hedge funds and registered investment companies, among others.  Nonetheless, they leave a number of questions unanswered and are subject to interpretation.  It will take some time "living with" the new rules and, perhaps, additional amendments or guidance on the part of the CFTC or its staff, in order to address all of the varied and unique situations raised as a result of these regulatory changes.

This article was originally published in September 2003 as a Schulte Roth & Zabel ALERT to clients. It was prepared by Lawrence T. Eckert, an Associate in the Corporate Investment Management Group of Schulte Roth & Zabel LLP in New York.  Mr. Eckert's practice focuses in the area of the regulation of private investment funds and their advisers, in general, and the regulation of commodity professionals, in particular.   Mr. Eckert was formerly a Special Counsel with the U.S. Commodity Futures Trading Commission's Division of Trading and Markets.
For further information, please contact Mr Eckert at Tel:  212 756 2597 or Email:
[email protected]

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