CFTC Adopts Rule Amendments Affecting CPOs and CTAs

Investment Management Update

Date: March 30, 2012


The Commodity Futures Trading Commission (CFTC) recently adopted amendments to Part 4 of the regulations implementing the Commodity Exchange Act (CEA).1 In relevant part, Part 4 of the regulations sets forth the registration and compliance obligations for commodity pool operators (CPOs) and commodity trading advisors (CTAs). First proposed in February 2011, the amendments implicate several sections of Part 4, including Rule 4.5, upon which many mutual funds and other registered investment companies rely to avoid registering as a CPO.2 As adopted, revised Rule 4.5 will significantly narrow the relief from CPO registration currently available for advisers to, and sponsors of, registered investment companies. Furthermore, since many advisers to investment companies rely on a CTA registration exemption that is dependent upon the investment company's ability to rely on Rule 4.5, the amendments to Rule 4.5 will result in more advisers to registered investment companies having to register as CTAs. The final rules will become effective 60 days after the publication of the Adopting Release in the Federal Register. Thus, amended Rule 4.5 will become effective on April 24, 2012.

In addition to the amendments to Rule 4.5 described more fully below, the amendments to Part 4 also:

  • Eliminate a CPO registration exemption widely used by managers of funds relying on the exemption from registration as an investment company under Section 3(c)(7) of the Investment Company Act of 1940, as amended (1940 Act).
  • Eliminate an exemption available in Rule 4.7 under the CEA to commodity pools whose participants are "qualified eligible participants" from the requirement to provide audited financial statements in annual reports.
  • Incorporate by reference, rather than by full inclusion of its specific text, the accredited investor standard set forth in Rule 502 of Regulation D under the Securities Act of 1933, as amended, into the definition of "qualified eligible person" in Rule 4.7.
  • Adopt new Rule 4.27, which requires registered CPOs and CTAs to annually file, respectively, Forms CPO-PQR and CTA-PR with the National Futures Association (NFA).
  • Adopt a mandatory Risk Disclosure Statement for CPOs and CTAs addressing certain risks specific to swap transactions.
Amendments to Rule 4.5

A registered investment company using commodity futures, options on commodities or commodity futures, or swaps is considered to be a commodity pool. The CEA defines "commodity pool" to include "any investment trust, syndicate or similar form of enterprise operated for the purpose of trading in" futures (including financial futures such as interest rate, currency, index and security futures), commodity options and, upon the issuance of final rules defining the term "swap," most types of swaps (excluding security-based swaps, but including interest rate, currency and other financial swaps, and swaps on broad-based securities indices). Unless the investment company can rely on the registration exclusion set forth in Rule 4.5, the investment company will be deemed to be a commodity pool and required to register as a CPO with the CFTC. The Adopting Release clarifies that the investment adviser to the investment company is the appropriate entity to register as a CPO where the exclusion to such registration under Rule 4.5 is not available to the investment company. Thus, the adviser to such an investment company will become subject to the ongoing compliance and reporting obligations applicable to CPOs.

The amendments to Rule 4.5 described in the Adopting Release have the effect of reinstating the trading and marketing limitations applicable to registered investment companies (but not with respect to other types of regulated entities), seeking to avoid registration as a CPO that existed prior to 2003.3 Prior to 2003, an entity claiming the exclusion set forth in Rule 4.5 was required to file a notice of eligibility and represent that the sponsored pool would not be and had not been marketing itself to the public as a vehicle for trading in the commodity futures or commodity options markets, and would limit the use of commodity futures or commodity options contracts for non-bona fide hedging purposes to 5 percent of the liquidation value of the entity's portfolio.

In 2003, the CFTC adopted amendments to Rule 4.5 that greatly expanded the scope of the exclusion it provided. More specifically, Rule 4.5, as amended in 2003, provided to registered investment companies an exclusion from the definition of CPO, regardless of the level of derivatives used by any such entity, thereby allowing registered investment companies to expand the use of derivatives and commodity interests beyond traditional bona fide hedging activities.

Partly in response to the increasing use of commodity interests by registered investment companies, in particular the use of such instruments by so-called "managed futures funds," the NFA petitioned the CFTC in 2010 to revise Rule 4.5 with respect to registered investment companies. In its petition, the NFA noted its concern that a number of registered investment companies were investing primarily in futures and other derivatives and marketing themselves as managed futures funds without complying with the requirements that otherwise would apply to registered CPOs.

Implicit in the concerns expressed by the NFA was the fact that, as registered investment companies, so-called managed futures funds were being offered to a wider and potentially less sophisticated group of investors than the group of investors to whom a registered commodity pool could be offered. Of particular concern to the NFA was the use by managed futures funds of controlled foreign corporations (CFCs) to gain exposure to derivatives and futures. Effectively, CFCs are unregulated entities - subject neither to regulation under the 1940 Act nor to the disclosure and reporting obligations of commodity pools under the CEA. Thus, the NFA contended that because CFCs were not subject to regulation under the 1940 Act, reliance by the investment company on Rule 4.5 might be inappropriate.

Trading Threshold

Under amended Rule 4.5, an investment company seeking to rely on the exclusion set forth in Rule 4.5 must either limit its exposure to derivatives to no more than 5 percent of the fund's liquidation value or ensure that the aggregate net notional value of the derivate positions of the fund not exceed the investment company's liquidation value.

Five percent limitation - For purposes of this standard, the aggregate initial margin and premiums required to establish commodity futures, options thereon or on commodities or swap positions cannot exceed 5 percent of the liquidation value of the registered investment company's portfolio, after taking into account unrealized profits and unrealized losses. While margin associated with "bona fide hedging purposes" (as defined in Rule 1.3(z)(1) and Rule 151.5) is excluded from the 5 percent limit, the limit includes all derivative trading, including swaps. As amended, Rule 4.5 does not differentiate between the active and passive use of futures. Thus, an investment company portfolio that employs futures to replicate a securities index or to simulate equity exposure would be subject to the trading threshold.

Net notional test - The CFTC reversed its position set forth in the Proposing Release and adopted a "net notional test" as an alternative trading threshold standard. Under this standard, an investment company could claim the exclusion under Rule 4.5 where the aggregate net notional value of the entity's derivative positions does not exceed the liquidation value of the fund. For purposes of the net notional test, futures contracts can be netted across exchanges, whereas swaps can be netted only if cleared by the same designated clearing organization.

The definition of a commodity futures contract includes most futures contracts (commodity futures contracts include futures on agricultural commodities, financial instruments and indices) and swaps. However, the definition of a "swap" remains unsettled as the rule defining such instruments is not yet finalized. Ultimately, the definition of swaps is expected to include most over-the-counter derivatives on assets other than a single security (i.e., swaps are expected to generally include interest rate swaps and broad-based security index options). Thus, for purposes of the percentage thresholds described in the Rule 4.5 tests, only swaps and other instruments subject to CFTC jurisdiction are counted in the numerator.

Marketing Restrictions

Amended Rule 4.5 imposes substantial limitations on the marketing activities of any investment company seeking to rely on the exclusion. A registered investment company claiming exclusion under amended Rule 4.5 may not be or have been "marketing participations to the public as or in a commodity pool or otherwise as or in a vehicle for trading in the commodity futures, commodity options, or swaps markets." In determining whether an investment company has complied with the marketing restrictions, the Adopting Release sets forth the following factors that the CFTC would consider in making such a determination:

  • The name of the fund.
  • Whether the fund's primary investment objective is tied to a commodity index.
  • Whether the fund makes use of a commodity subsidiary for its derivatives trading.
  • Whether the fund's marketing materials, including its prospectus or disclosure document, refer to the benefits of the use of derivatives in a portfolio or make comparisons to a derivatives index.
  • Whether, during the course of its normal trading activities, the fund or entity on its behalf has a net short speculative exposure to any commodity through a direct or indirect investment in other derivatives.
  • Whether the futures/options/swap transactions engaged in by the fund or on behalf of the fund will directly or indirectly be its primary source of potential gains and losses.
  • Whether the fund is explicitly offering a managed futures strategy.

Although the CFTC noted that no single factor would be determinative, the Adopting Release indicates that the CFTC will give more weight to the fund's investment strategy in determining whether a registered investment company is operating as a de facto commodity pool. However, if a registered investment company offers a strategy with several indicia of a managed futures strategy yet avoids explicitly describing the strategy as such in its offering materials, the registered investment company may still be found to have violated the marketing limitations.

Use of CFCs or Commodity Subsidiaries

CFCs or commodity subsidiaries used for trading in commodity interests by registered investment companies now will be required to register as CPOs with the CFTC, unless the CFC can claim an exemption or exclusion from registration in its own right as opposed to relying on an exclusion that may be available to the affiliated investment company. The CFTC observed in the Adopting Release that some investment companies that invest in commodity interests through CFCs previously took the position that the CFC merely was a "subdivision" of the investment company rather than a separate commodity pool, and therefore could rely on the Rule 4.5 exclusion of the investment company. Given that the CFTC has rescinded the CPO registration exemption in Rule 4.13(a)(4) previously relied upon by some commodity subsidiaries, the sponsors of such commodity subsidiaries will likely need to register unless they can rely on another registration exemption.

One of the key issues associated with the use of CFCs by investment companies is whether or not income generated by the CFC can be treated as qualifying income for purposes of Subchapter M of the Internal Revenue Code of 1986, as amended. The Internal Revenue Service (IRS) previously addressed this issue on a case-by-case basis through private letter rulings. Though not addressed in the recent CFTC rulemaking, it is worth noting that in July 2011 the IRS suspended issuing such private letter rulings pending a review of associated policy issues, including the degree to which CFCs are being used to avoid regulatory requirements under the federal securities laws. More specifically, the IRS notified the mutual fund industry that it would not issue further private letter rulings until its staff had an opportunity to examine the overall set of issues and consider guidance of broader applicability. While funds that have received a private letter ruling regarding treatment of CFC income can continue to rely on the ruling, the moratorium may represent an obstacle to the launch of new funds seeking to treat income from a CFC as qualifying income for purposes of Subchapter M.

Registration as a CTA

Many investment advisers to registered investment companies presently rely on Rule 4.14(a)(8) to avoid registration as a CTA. Rule 4.14(a)(8) provides relief from registration as a CTA for advisers that solely advise one or more of the following: registered investment companies that can rely on Rule 4.5, certain other exempt investment funds or non-U.S. funds. If a registered investment company does not satisfy the requirements for an exclusion under amended Rule 4.5, then it is not a "qualifying entity" for purposes of Rule 4.14(a)(8), and the adviser to any such investment company may no longer be able to rely on Rule 4.14(a)(8) for an exemption from registration as a CTA. As a result, any such adviser would need to register as a CTA unless another exemption to registration can be found.

Harmonization of Compliance Requirements

In response to concerns that registered investment companies whose advisers would become subject to registration as CPOs under revised Rule 4.5 may be subject to duplicative, inconsistent and potentially conflicting disclosure and reporting requirements, the CFTC has proposed amendments to its regulations that are intended to align such disclosure and reporting requirements with the requirements of the 1940 Act.4 The proposals set forth in the Harmonization Release address the following areas:

  • The timing and delivery of disclosure documents to prospective participants.
  • The requirement that a sponsor receive a signed acknowledgment of disclosure documents before accepting or receiving funds, securities or other property from a prospective participant.
  • The frequency of required updates for relevant disclosure documents.
  • The timing of financial reporting to participants.
  • The requirement that a CPO maintain its books and records at its main business office.
  • The required disclosure of fees, including break-even analysis.
  • The required disclosure of past performance information.
  • The inclusion of mandatory certification language.
  • The permitted use by the SEC of a summary prospectus for open-end registered investment companies.

Comments on the Harmonization Release are due on or before April 24, 2012.

Compliance Dates

As noted above, amended Rule 4.5 becomes effective on April 24, 2012. However, registered investment companies and their investment advisers generally will have until the end of 2012 to begin complying with the amended rule.

CPO registration - Given that the rule defining the term "swap" has not yet been finalized, the CFTC Adopting Release provides that advisers to registered investment companies that do not satisfy amended Rule 4.5 must register as CPOs no later than the later of December 31, 2012 or 60 days after the effective date of the final rulemaking further defining the term "swap," which the CFTC is currently expected to publish by mid-2012.

Recordkeeping and disclosure requirements - Advisers to registered investment companies that will be required to register under amended Rule 4.5 will not be subject to the CFTC's recordkeeping, reporting and disclosure requirements until 60 days after the effective date of a final rule implementing the CFTC's proposed effort to harmonize the compliance obligations as set forth in the Harmonization Release.


1Commodity Pool Operators and Commodity Trading Advisors: Amendments to Compliance Obligations, CFTC Rel. No. RIN 3038-AD30 (Feb. 9, 2012) (Adopting Release).

2Commodity Pool Operators and Commodity Trading Advisors: Amendments to Compliance Obligations; Proposed Rule, CFTC Rel. No. RIN 3038-AD30 (Feb. 11, 2011) (Proposing Release).

3It is worth noting that banks, benefit plans and insurance companies currently relying on the exclusion provided under Rule 4.5 largely are unaffected by the changes described in the Adopting Release and may continue to conduct their commodity pool businesses without registration.

4Harmonization of Compliance Obligations for Registered Investment Companies Required To Register as Commodity Pool Operators, CFTC Rel. No. 2012-3388 (Feb. 24, 2012) (Harmonization Release).