Investment Management Update
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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.