CFTC Adopts New and Amended Exclusions for Investment Funds and Advisers from CPO and CTA Regulation
by Merrill R. Steiner
On August 8, 2003, the Commodity Futures Trading Commission (CFTC) adopted rule amendments (Amendments) under the Commodity Exchange Act, as amended (CEA), that provide registration and other regulatory relief for certain investment funds and investment advisers that would otherwise be registered and/or regulated as Commodity Pool Operators (CPOs) and/or Commodity Trading Advisors (CTAs).1 The Amendments became effective immediately. As more fully described below, funds or advisers are not required to re-file their notices of eligibility either to maintain the relief they previously claimed or to invest in accordance with the amended rules.
The Amendments generally take the following form:
• For investment companies registered under the Investment Company Act of 1940, as amended (1940 Act) (and separate accounts of insurance companies, fiduciary trust or custodial accounts and certain qualified pension plans) that trade in commodity interests:2
* Expand and modify the exclusion from status as a CPO, which had been available under Rule 4.5.
• For certain hedge funds or private investment companies not registered under the 1940 Act (with limited investments), that trade in commodity interests to a limited extent and/or through fund of fund arrangements, are offered and sold without marketing to the public in the United States and are sold to sophisticated or high net worth investors:
* Add a new exemption from CPO registration under Rule 4.13.
• For certain hedge funds or private investment companies, not registered under the 1940 Act (with more limited investors), that trade in commodity interests, are offered and sold without marketing to the public in the United States and are sold to a more limited class of sophisticated or high net worth investors:
* Add a new exemption from CPO registration under Rule 4.13.
• For investment advisers to the foregoing funds, whether or not registered under the 1940 Act:
* Add an exemption category and requirements to the exemption from CTA registration under Rule 4.14(a)(8).
• For investment advisers that do not furnish commodity interest trading advice to more than 15 persons during a 12-month period:
* Clarify with respect to counting the number of persons, the exemption from CTA registration available under Section 4m(1) of the CEA.
Background: Registration and Regulation of CPOs and CTAs
Commodity Pool Operators (CPOs). Without an exclusion or exemption, such as those available in the Amendments, an investment fund’s adviser or promoter that solicits or accepts funds or other assets, directly or through capital contributions, for the purpose of trading in commodity interests, is a CPO, and the investment fund, as a separate legal entity, is a commodity pool.3 The CPO and its principals and associated persons, including salesmen, are required to register as such and the commodity pool is subject to regulation, including disclosures to investors (updated on a regular basis), accounting and reporting requirements, and advertising restrictions.
Commodity Trading Advisors (CTAs). Without an exclusion or exemption, such as those available in the Amendments, an investment fund’s investment adviser that, as part of its business and for compensation or profit, provides advice regarding the value of trading, or the advisability of trading, commodity interests, that is tailored to the investment goals and policies of the investment fund, is a CTA. The CTA and its principals and associated persons, including salesmen, are required to register as such.
These requirements apply whether or not the investment fund is registered under the 1940 Act and/or the investment adviser is registered under federal or state law.
A. Rule 4.5 Amendment: Effect on Registered Investment Companies
For registered investment companies (and separate accounts of insurance companies, fiduciary trust or custodial accounts and certain qualified pension plans) that trade in commodity interests, the Amendments to Rule 4.5 delete:
• all limits on investing in commodity interests (previously limited by Rule 4.5.); and
• all restrictions on marketing the fund as a vehicle for trading commodity interests (previously restricted by Rule 4.5).
In place of these limits, the Amendments require:
• disclosure to investors that the fund’s adviser or promoter has claimed exclusion from the CPO status and is not subject to CPO registration and regulation under the CEA.
The Amendments retain the requirements that the fund will:
• submit to special calls made by the CFTC; and
• file, and update as needed, a notice of eligibility with the National Futures Association.
Previous CFTC Limits and No-Action Relief Still Available: The Adopting Release permits funds and advisers who previously claimed relief under Rule 4.5 or temporary no-action relief to maintain that relief by continuing to comply with the commodity interest trading limitations applicable to that previously claimed relief.4
Adviser May Qualify for Both Rule 4.5 Exclusion and Rule 4.13 Exemption. The Amendments also make clear that qualifying for the exclusion under Rule 4.5 will not affect the ability of an adviser or promoter to qualify for exemptions from CPO registration under Rule 4.13, which is applicable to certain hedge funds or private investment companies not registered under the 1940 Act, as described below. Accordingly, an adviser or promoter who is excluded from the definition of CPO pursuant to Rule 4.5 may be deemed a CPO, but exempt from registration under Rule 4.13.
B. New Rule 4.13(a)(3): Effect on Certain Hedge Funds or Private Investment Companies Not Registered Under the 1940 Act (With Limited Investments)
New Rule 4.13(a)(3) adds an exemption from CPO registration for certain hedge funds or private investment companies not registered under the 1940 Act that trade in commodity interests to a limited extent and/or through fund of fund arrangements, and sell their shares in private offerings to sophisticated or high net worth investors. Specifically, new Rule 4.13(a)(3) provides that a fund:
• may invest no more than 5% of the liquidation value of the fund (with certain adjustments) in initial margin and premiums to establish commodity interest positions; or
• may invest no more than 100% of the liquidation value of the fund (with certain adjustments) as the aggregate net notional value of the fund’s commodity interest positions;5 or
• as a fund that invests in other funds (without regard to the level of commodity interest trading engaged in by the other funds (investee funds)), may invest no more than 50% of the fund’s assets in the aggregate in investee funds; or
• as a fund that does not invest any of the fund’s assets directly in commodity interest trading, may invest any amount in investee funds, each having a CPO that is either: (1) claiming exemption from registration under Rule 4.13(a)(3); or (2) a registered CPO that is complying with the trading restrictions of Rule 4.13(a)(3); or
• as a fund that invests in investee funds, may do so in a manner that complies with one of the other examples of fund of funds investments that are provided in Appendix A of the CFTC release adopting the Amendments
Previous CFTC Limits and No-Action Relief Still Available. The Adopting Release permits funds and advisers who previously claimed temporary no-action relief to maintain that relief by continuing to comply with the commodity interest trading limitations applicable to that previously claimed relief.6
Treatment of Fund of Funds. In the fund of funds context, where an investment fund invests in investee funds (underlying funds that invest in commodity interests), the investment fund technically does not need to make the new required disclosure if it continues to comply with the lower limits of the previous no-action relief described above. As a precaution, however, these funds and their advisers should make the disclosure required to qualify for the higher limits of Rule 4.13(a)(3), in case the fund were to trade above the lower limits of the no-action relief, and because the disclosure is not difficult. The guidance for these cases in Appendix A of the Amendments presumes that the investment fund and adviser will comply with the application of the trading limits of Rule 4.13(a)(3).
Additional Requirements: Exempt Offering and Limited Class of Investors. In addition to complying with the limits on investments in commodity interests:
• the fund’s shares must be exempt from registration under the Securities Act of 1933, as amended (1933 Act), and not offered or sold in a public offering in the United States;
• each investor in the pool must be an “accredited investor” (or trust formed by an “accredited investor” for family member(s)), a “knowledgeable employee,” or a “qualified eligible person,” as defined in securities and commodities rules; and
• the fund’s shares may not be marketed as, or in a vehicle for, trading in the commodity futures or options on futures markets.
C. New Rule 4.13(a)(4): Effect on Certain Hedge Funds or Private Investment Companies Not Registered Under the 1940 Act (With More Limited Investors)
New Rule 4.13(a)(4) adds an exemption from CPO registration for certain hedge funds or private investment companies not registered under the 1940 Act that trade in commodity interests, where interests in the fund are offered and sold without marketing to the public in the United States and are sold to a more limited class of sophisticated or high net worth investors. Specifically, new Rule 4.13(a)(4) provides that:
• the fund’s shares must be exempt from registration under the 1933 Act, and not offered or sold in a public offering in the United States;
• each natural person investor in the pool must be a “qualified eligible person;” and
• each non-natural person investor in the pool must be a “qualified eligible person” or an “accredited investor,” as defined in securities and commodities rules.
Additional Criteria for CPO Registration Exemption and Commodity Pool Exemption For Funds Not Registered Under the 1940 Act: In addition to complying with the criteria of new Rules 4.13(a)(3) and 4.13(a)(4), described above, the new rules require the adviser/promoter of the fund to:
• furnish each prospective investor in the fund a written disclosure that:
— contains: (1) a statement that the adviser/ promoter is exempt from registration with the CFTC as a CPO and, therefore, unlike a registered CPO, it is not required to deliver a Disclosure Document and a certified annual report to investors in the fund; and (2) a description of the criteria pursuant to which it qualifies for such exemption from registration; and
— is furnished no later than the time the adviser/ promoter delivers a subscription agreement to a prospective investor in the fund.
• file and update, as necessary, a notice of eligibility with the National Futures Association that:
— provides the section number of the exemption claimed and represents that the fund will be operated in accordance with the criteria of the section; and
— is filed no later than the time the adviser/ promoter delivers a subscription agreement to a prospective investor in the fund.7
• make books and records for its activities as an exempt CPO and keep them for five years from the date of preparation (readily accessible during the first two years) and available for inspection by the SEC and other regulatory agencies;
• submit to special calls made by the CFTC to monitor compliance with Rule 4.13 criteria; and
• if the fund distributes an annual report to investors in the fund, the annual report must be in accordance with GAAP and, if certified by an independent public accountant, so certified in accordance with CFTC Rule 1.16, as applicable.
D. Rule 4.14(a)(8): Effect on Investment Advisers to the Foregoing Funds, Whether or Not the Funds are Registered Under the 1940 Act
For investment advisers to the foregoing funds, whether or not the funds are registered under the 1940 Act, the Amendments provide, under Rule 4.14(a)(8), an exemption from registration as a CTA for an investment adviser that:
• is registered with the SEC or an applicable state regulatory agency or is exempt from registration as such, or excluded from the definition of investment adviser;
• provides “securities advice” or (as newly permitted under the Amendments) “other investment advice” to the investment fund, provided that its commodity interest trading advice is solely incidental to its business of providing such securities or other investment advice to the investment fund operating under Rule 4.5, Rule 4.13(a)(3) or Rule 4.13(a)(4) (or certain commodity pools organized and operated outside the United States that offer and sell shares exclusively to non-U.S. Persons, with certain exceptions and no marketing to other than non-U.S. Persons or from within the United States);
• has filed, and keeps updated, a notice of eligibility for exemption from registration under Rule 4.14(a)(8);
• files its notice of eligibility no later than the “time it delivers an advisory agreement for the trading program pursuant to which it will offer commodity interest advice to a client” (including a fund) (rather than “the date upon which such person intends to engage in business as” a CTA, which applied before the Amendments);
• may not otherwise hold itself out as a CTA (no change under the Amendments);
• makes books and records for its activities as an exempt CTA, including books and records demonstrating eligibility for and compliance with the criteria of this exemption, and keeps them for five years from the date of preparation (readily accessible during the first two years) and available for inspection by the SEC and other regulatory agencies (new requirement under the Amendments); and
• submits to special calls made by the CFTC to monitor compliance (new requirement under
the Amendments).
E. Funds and Advisers Not Required to Re-file Their Notices of Eligibility
To maintain the relief they previously claimed or to invest in accordance with the rules as amended by the Amendments, funds and advisers are not required to re-file their notices of eligibility. Funds and advisers that continue to comply with the limitations of previously claimed relief do not have to take any other action to take advantage of the other exemptions made available by the Amendments. For example, funds and advisers that continue to comply with the limitations of previously claimed relief under Rule 4.5 or the no-action relief related to Rule 4.5 or Rules 4.13(a)(3) or (a)(4), are not subject to the revised disclosure requirements of Rule 4.5 or Rule 4.13, as applicable.
F. Clarification of Provisions Regarding Investment Advisers That Do Not Furnish Commodity Interest Trading Advice to More Than 15 Persons During a 12-Month Period
Finally, for investment advisers that are exempt from registration as CTAs based on the fact that they do not furnish commodity interest trading advice to more than 15 persons during a 12-month period, and do not hold themselves out generally to the public as a CTA, the Amendments clarify, with respect to counting the number of persons, that the following are deemed to be a single person:
• A natural person, and:
— Any minor child of the natural person;
— Any relative, spouse, or relative of the spouse of the natural person who has the same principal residence;
— All accounts of which the natural person and/or the persons referred to in this section for natural persons are the only primary beneficiaries; and
— All trusts of which the natural person and/or the persons referred to in this section for natural persons are the only primary beneficiaries.
• A corporation, general partnership, limited partnership, limited liability company, trust (other than a trust referred to above) or other legal organization (any of which, a “legal organization”) that receives commodity interest trading advice based on its investment objectives rather than the individual investment objectives of its shareholders, partners, limited partners, members, or beneficiaries (any of which, an “owner”); and two or more legal organizations that have identical owners8;
• A general partner of a limited partnership, or other person acting as a CTA to the partnership, may count the limited partnership as one person;
• A manager or managing member of a limited liability company, or any other person acting as a CTA to the company, may count the limited liability company as one person; and
• A CTA that has its principal office and place of business outside of the United States, its territories or possessions must count only clients that are residents of the United States, its territories
and possessions.
The CTA is not deemed to be holding itself out generally to the public as a CTA, solely because it participates in a non-public offering of interests in a fund under the 1933 Act.
1 Additional Registration and Other Regulatory Relief for Commodity Pool Operators and Commodity Trading Advisors; Past Performance Issues, 68 FR 47221 (August 8, 2003) (the “Adopting Release”). Among other regulations, the Amendments addressed aspects of the calculation and presentation of past performance by CPOs and CTAs under CFTC Rule 4.35, certain communications by CPOs and CTAs prior to Disclosure Document delivery, duplicative disclosure and reporting requirements for CPOs regarding master/feeder funds, CPOs’ distribution of Account Statements and Annual Reports electronically, and use of facsimile signatures and other signature requirements. These topics are not summarized in this Alert.
2 “Commodity interests” include any futures contract (including financial futures), option on a futures contract(s) and any contract, agreement or transaction subject to CFTC regulation under Sections 4c or 19 of the CEA.
3 Both the investment adviser and the investment fund must comply with criteria in the rules that are the subject of the Amendments for the CPO and CTA registration exemptions to apply to the investment adviser and for the investment fund to avoid regulation as a commodity pool. An investment adviser that advises an investment fund that invests in commodity interests, but does not engage in operating the investment fund or, in connection with such operation, solicit funds or assets for the investment fund, is not a CPO and does not need the CPO registration exemption. Such an adviser may avoid registration with the CFTC by meeting only the CTA registration exemption criteria, as more fully described herein.
4 Before the Amendments were adopted, a registered investment company that sought exclusion under Rule 4.5 could not invest more than 5% of its liquidation value in initial margins and premiums for commodity interests, with certain adjustments, in addition to any amount invested in commodity interests that met the technical definition of bona fide hedging. During the period when the CFTC was proposing the Amendments for adoption (from October 28, 2002 to August 8, 2003), the CFTC took a no-action position that provided an alternative test that an investment fund could meet: with respect to commodity interest positions of the fund (other than bona fide hedging positions), the aggregate notional value of such positions could not exceed the liquidation value of the fund, with certain adjustments. This alternative test meant a fund could invest more in certain types of commodity interests, such as S&P 500 Stock Price Index(R) futures contracts, than the fund could under the 5% limit described herein.
5 Notional value is calculated for each futures position by multiplying the number of contracts by the size of the contract, in contract units (taking into account any multiplier specified in the contract), by the current market price per unit, and for each option position by multiplying the number of contracts by the size of the contract, adjusted by its delta, in contract units (taking into account any multiplier specified in the contract), by the strike price per unit. The fund may net contracts with the same underlying commodity across designated contract markets, registered derivatives transaction execution facilities and foreign boards of trade.
6 Previously, there was no CFTC regulation that provided an exemption for hedge funds or private investment companies as described above. Under CFTC no-action relief, available beginning on March 12, 2003, an investment adviser could be exempt from CPO and CTA registration if either: (1) the aggregate initial margin and premiums required to establish the fund’s commodity interest positions, at the time of the most recent position, does not exceed 2% of the liquidation value of the fund (with certain adjustments); or (2) the aggregate net notional value of the fund’s commodity interest positions, at the time of the most recent position, does not exceed 50% of the liquidation value of the fund (with certain adjustments).
7 Note that the fund does not need to re-file a notice if it filed a notice representing it would comply with the no-action relief for CPOs, even though the fund trades within the higher limits of the amendments to Rule 4.13(a)(3), which is discussed herein.
8 An owner must be counted in its own capacity as a person if the CTA provides advisory services to the owner separate and apart from the advisory services provided to the legal organization, but if an owner is a client in this way, it will not on that basis affect the counting with regard to any other owner. |
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