Investment Management Update

March 2012

CFTC Adopts Rule Amendments Affecting CPOs and CTAs

Introduction • Eliminate an exemption available in Rule 4.7 under the CEA to commodity pools whose participants The Commodity Futures Trading Commission (CFTC) are “qualified eligible participants” from the recently adopted amendments to Part 4 of the regulations requirement to provide audited financial 1 statements in annual reports. implementing the Commodity Exchange Act (CEA). In • Incorporate by reference, rather than by full relevant part, Part 4 of the regulations sets forth the inclusion of its specific text, the accredited registration and compliance obligations for commodity pool investor standard set forth in Rule 502 of operators (CPOs) and commodity trading advisors (CTAs). Regulation D under the Securities Act of 1933, as First proposed in February 2011, the amendments implicate amended, into the definition of “qualified eligible several sections of Part 4, including Rule 4.5, upon which person” in Rule 4.7. many mutual funds and other registered investment • Adopt new Rule 4.27, which requires registered 2 CPOs and CTAs to annually file, respectively, Forms companies rely to avoid registering as a CPO. As adopted, CPO-PQR and CTA-PR with the National Futures revised Rule 4.5 will significantly narrow the relief from CPO Association (NFA). registration currently available for advisers to, and sponsors • Adopt a mandatory Risk Disclosure Statement for of, registered investment companies. Furthermore, since CPOs and CTAs addressing certain risks specific to many advisers to investment companies rely on a CTA swap transactions. registration exemption that is dependent upon the investment company’s ability to rely on Rule 4.5, the Amendments to Rule 4.5 amendments to Rule 4.5 will result in more advisers to Background registered investment companies having to register as CTAs. The final rules will become effective 60 days after the A registered investment company using commodity futures, publication of the Adopting Release in the Federal Register. options on commodities or commodity futures, or swaps is Thus, amended Rule 4.5 will become effective on April 24, considered to be a commodity pool. The CEA defines 2012. “commodity pool” to include “any investment trust, syndicate or similar form of enterprise operated for the In addition to the amendments to Rule 4.5 described more purpose of trading in” futures (including financial futures fully below, the amendments to Part 4 also: such as interest rate, currency, index and security futures), • Eliminate a CPO registration exemption widely commodity options and, upon the issuance of final rules used by managers of funds relying on the defining the term “swap,” most types of swaps (excluding exemption from registration as an investment security-based swaps, but including interest rate, currency company under Section 3(c)(7) of the Investment and other financial swaps, and swaps on broad-based Company Act of 1940, as amended (1940 Act). securities indices). Unless the investment company can rely

ATLANTA CINCINNATI CLEVELAND COLUMBUS DAYTON NEW YORK WASHINGTON, D.C. ATTORNEY ADVERTISING Investment Management Update March 2012

on the registration exclusion set forth in Rule 4.5, the Implicit in the concerns expressed by the NFA was the fact investment company will be deemed to be a commodity that, as registered investment companies, so-called pool and required to register as a CPO with the CFTC. The managed futures funds were being offered to a wider and Adopting Release clarifies that the investment adviser to potentially less sophisticated group of investors than the the investment company is the appropriate entity to group of investors to whom a registered commodity pool register as a CPO where the exclusion to such registration could be offered. Of particular concern to the NFA was the under Rule 4.5 is not available to the investment company. use by managed futures funds of controlled foreign Thus, the adviser to such an investment company will corporations (CFCs) to gain exposure to derivatives and become subject to the ongoing compliance and reporting futures. Effectively, CFCs are unregulated entities – subject obligations applicable to CPOs. neither to regulation under the 1940 Act nor to the disclosure and reporting obligations of commodity pools The amendments to Rule 4.5 described in the Adopting under the CEA. Thus, the NFA contended that because CFCs Release have the effect of reinstating the trading and were not subject to regulation under the 1940 Act, reliance marketing limitations applicable to registered investment by the investment company on Rule 4.5 might be companies (but not with respect to other types of regulated inappropriate. entities), seeking to avoid registration as a CPO that existed prior to 2003.3 Prior to 2003, an entity claiming the Trading Threshold exclusion set forth in Rule 4.5 was required to file a notice of eligibility and represent that the sponsored pool would Under amended Rule 4.5, an investment company seeking not be and had not been marketing itself to the public as a to rely on the exclusion set forth in Rule 4.5 must either vehicle for trading in the commodity futures or commodity limit its exposure to derivatives to no more than 5 percent options markets, and would limit the use of commodity of the fund’s liquidation value or ensure that the aggregate futures or commodity options contracts for non-bona fide net notional value of the derivate positions of the fund not hedging purposes to 5 percent of the liquidation value of exceed the investment company’s liquidation value. the entity’s portfolio. Five percent limitation – For purposes of this standard, the In 2003, the CFTC adopted amendments to Rule 4.5 that aggregate initial margin and premiums required to greatly expanded the scope of the exclusion it provided. establish commodity futures, options thereon or on More specifically, Rule 4.5, as amended in 2003, provided commodities or swap positions cannot exceed 5 percent to registered investment companies an exclusion from the of the liquidation value of the registered investment definition of CPO, regardless of the level of derivatives used company’s portfolio, after taking into account unrealized by any such entity, thereby allowing registered investment profits and unrealized losses. While margin associated companies to expand the use of derivatives and commodity with “bona fide hedging purposes” (as defined in Rule interests beyond traditional bona fide hedging activities. 1.3(z)(1) and Rule 151.5) is excluded from the 5 percent limit, the limit includes all derivative trading, including Partly in response to the increasing use of commodity swaps. As amended, Rule 4.5 does not differentiate interests by registered investment companies, in between the active and passive use of futures. Thus, an particular the use of such instruments by so-called investment company portfolio that employs futures to “managed futures funds,” the NFA petitioned the CFTC in replicate a securities index or to simulate equity exposure 2010 to revise Rule 4.5 with respect to registered would be subject to the trading threshold. investment companies. In its petition, the NFA noted its concern that a number of registered investment Net notional test – The CFTC reversed its position set forth companies were investing primarily in futures and other in the Proposing Release and adopted a “net notional test” derivatives and marketing themselves as managed futures as an alternative trading threshold standard. Under this funds without complying with the requirements that standard, an investment company could claim the exclusion otherwise would apply to registered CPOs. under Rule 4.5 where the aggregate net notional value of the entity’s derivative positions does not exceed the

2 Investment Management Update March 2012

liquidation value of the fund. For purposes of the net • Whether the futures/options/swap transactions notional test, futures contracts can be netted across engaged in by the fund or on behalf of the fund exchanges, whereas swaps can be netted only if cleared by will directly or indirectly be its primary source of the same designated clearing organization. potential gains and losses. • Whether the fund is explicitly offering a managed The definition of a commodity futures contract includes futures strategy. most futures contracts (commodity futures contracts Although the CFTC noted that no single factor would be include futures on agricultural commodities, financial determinative, the Adopting Release indicates that the CFTC instruments and indices) and swaps. However, the will give more weight to the fund’s investment strategy in definition of a “swap” remains unsettled as the rule determining whether a registered investment company is defining such instruments is not yet finalized. Ultimately, operating as a de facto commodity pool. However, if a the definition of swaps is expected to include most over- registered investment company offers a strategy with the-counter derivatives on assets other than a single several indicia of a managed futures strategy yet avoids security (i.e., swaps are expected to generally include explicitly describing the strategy as such in its offering interest rate swaps and broad-based security index materials, the registered investment company may still be options). Thus, for purposes of the percentage thresholds found to have violated the marketing limitations. described in the Rule 4.5 tests, only swaps and other instruments subject to CFTC jurisdiction are counted in the Use of CFCs or Commodity Subsidiaries numerator. CFCs or commodity subsidiaries used for trading in Marketing Restrictions commodity interests by registered investment companies now will be required to register as CPOs with the CFTC, Amended Rule 4.5 imposes substantial limitations on the unless the CFC can claim an exemption or exclusion from marketing activities of any investment company seeking to registration in its own right as opposed to relying on an rely on the exclusion. A registered investment company exclusion that may be available to the affiliated investment claiming exclusion under amended Rule 4.5 may not be or company. The CFTC observed in the Adopting Release that have been “marketing participations to the public as or in a some investment companies that invest in commodity commodity pool or otherwise as or in a vehicle for trading interests through CFCs previously took the position that the in the commodity futures, commodity options, or swaps CFC merely was a “subdivision” of the investment company markets.” In determining whether an investment company rather than a separate commodity pool, and therefore has complied with the marketing restrictions, the Adopting could rely on the Rule 4.5 exclusion of the investment Release sets forth the following factors that the CFTC would company. Given that the CFTC has rescinded the CPO consider in making such a determination: registration exemption in Rule 4.13(a)(4) previously relied upon by some commodity subsidiaries, the sponsors of such • The name of the fund. commodity subsidiaries will likely need to register unless • Whether the fund’s primary investment objective is tied to a commodity index. they can rely on another registration exemption. • Whether the fund makes use of a commodity subsidiary for its derivatives trading. One of the key issues associated with the use of CFCs by • Whether the fund’s marketing materials, including investment companies is whether or not income generated its prospectus or disclosure document, refer to the by the CFC can be treated as qualifying income for purposes benefits of the use of derivatives in a portfolio or of Subchapter M of the Internal Revenue Code of 1986, as make comparisons to a derivatives index. amended. The Internal Revenue Service (IRS) previously • Whether, during the course of its normal trading addressed this issue on a case-by-case basis through private activities, the fund or entity on its behalf has a net letter rulings. Though not addressed in the recent CFTC short speculative exposure to any commodity through a direct or indirect investment in other rulemaking, it is worth noting that in July 2011 the IRS derivatives. suspended issuing such private letter rulings pending a

3 Investment Management Update March 2012

review of associated policy issues, including the degree to accepting or receiving funds, securities or other which CFCs are being used to avoid regulatory requirements property from a prospective participant. under the federal securities laws. More specifically, the IRS • The frequency of required updates for relevant notified the mutual fund industry that it would not issue disclosure documents. • The timing of financial reporting to participants. further private letter rulings until its staff had an • The requirement that a CPO maintain its books and opportunity to examine the overall set of issues and records at its main business office. consider guidance of broader applicability. While funds that • The required disclosure of fees, including break- have received a private letter ruling regarding treatment of even analysis. CFC income can continue to rely on the ruling, the • The required disclosure of past performance moratorium may represent an obstacle to the launch of information. new funds seeking to treat income from a CFC as qualifying • The inclusion of mandatory certification language. • income for purposes of Subchapter M. The permitted use by the SEC of a summary prospectus for open-end registered investment Registration as a CTA companies. Comments on the Harmonization Release are due on or Many investment advisers to registered investment before April 24, 2012. companies presently rely on Rule 4.14(a)(8) to avoid registration as a CTA. Rule 4.14(a)(8) provides relief from Compliance Dates registration as a CTA for advisers that solely advise one or more of the following: registered investment companies As noted above, amended Rule 4.5 becomes effective on that can rely on Rule 4.5, certain other exempt investment April 24, 2012. However, registered investment companies funds or non-U.S. funds. If a registered investment company and their investment advisers generally will have until the does not satisfy the requirements for an exclusion under end of 2012 to begin complying with the amended rule. 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 CPO registration – Given that the rule defining the term investment company may no longer be able to rely on Rule “swap” has not yet been finalized, the CFTC Adopting 4.14(a)(8) for an exemption from registration as a CTA. As a Release provides that advisers to registered investment result, any such adviser would need to register as a CTA companies that do not satisfy amended Rule 4.5 must unless another exemption to registration can be found. register as CPOs no later than the later of December 31, 2012 or 60 days after the effective date of the final Harmonization of Compliance Requirements rulemaking further defining the term “swap,” which the CFTC is currently expected to publish by mid-2012. In response to concerns that registered investment companies whose advisers would become subject to Recordkeeping and disclosure requirements – Advisers to registration as CPOs under revised Rule 4.5 may be subject registered investment companies that will be required to to duplicative, inconsistent and potentially conflicting register under amended Rule 4.5 will not be subject to the disclosure and reporting requirements, the CFTC has CFTC’s recordkeeping, reporting and disclosure proposed amendments to its regulations that are intended requirements until 60 days after the effective date of a final to align such disclosure and reporting requirements with rule implementing the CFTC’s proposed effort to harmonize the requirements of the 1940 Act.4 The proposals set forth the compliance obligations as set forth in the in the Harmonization Release address the following areas: Harmonization Release.

• The timing and delivery of disclosure documents to prospective participants. • The requirement that a sponsor receive a signed acknowledgment of disclosure documents before

4 Investment Management Update March 2012

FOR MORE INFORMATION 2 Commodity Pool Operators and Commodity Trading Advisors: For more information, please contact: Amendments to Compliance Obligations; Proposed Rule, CFTC Rel. No. RIN 3038-AD30 (Feb. 11, 2011) (Proposing Release). Michael V. Wible 3 It is worth noting that banks, benefit plans and insurance 614.469.3297 companies currently relying on the exclusion provided under Rule [email protected] 4.5 largely are unaffected by the changes described in the Adopting Release and may continue to conduct their commodity Donald S. Mendelsohn pool businesses without registration. 513.352.6546 4 Harmonization of Compliance Obligations for Registered [email protected] Investment Companies Required To Register as Commodity Pool Operators, CFTC Rel. No. 2012-3388 (Feb. 24, 2012) Richard S. Heller (Harmonization Release). 212.908.3907 [email protected]

James P. Jalil 212.908.3976 [email protected]

JoAnn M. Strasser 614.469.3265 [email protected]

Terrence O. Davis 202.973.2735 [email protected]

Cassandra W. Borchers 513.352.6632 [email protected]

***

This advisory bulletin may be reproduced, in whole or in part, with the prior permission of Thompson Hine LLP and acknowledgment of its source and copyright. This publication is intended to inform clients about legal matters of current interest. It is not intended as legal advice. Readers should not act upon the information contained in it without professional counsel.

This document may be considered attorney advertising in some jurisdictions.

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