Cftc Reinstates Restrictions on Registered Investment Companies

CLIENT MEMORANDUM

CFTC REINSTATES RESTRICTIONS ON REGISTERED INVESTMENT COMPANIES

AGENCY PROPOSES HARMONIZATION WITH SEC RULES

Since 2003, Commodity Futures Trading Commission Rule 4.5 has excluded from the definition of commodity pool operator all investment companies registered as such with the Securities and Exchange Commission. Such registered investment companies (“RICs”) have been permitted, upon filing a notice of eligibility with the CFTC, to engage in an unlimited level of futures trading without CFTC registration or regulation. On February 9, 2012, however, the CFTC adopted amendments to Rule 4.5 that generally reinstate certain investment and marketing restrictions contained in Rule 4.5 prior to 2003 (the “Final Rule,” and the release adopting the Final Rule, the “Adopting Release”). 1 The CFTC acknowledged that these restrictions, in conjunction with the swap rulemakings, once finalized,2 may reduce the ability of operators of futures-trading RICs to rely on Rule 4.5, both as compared to the current Rule 4.5 and the pre- 2003 version.

The amendments to Rule 4.5 become effective April 24, 2012. The CFTC made clear in the Adopting Release that operators of RICs relying on Rule 4.5 on or prior to the effective date that do not qualify for the exclusion under the amended Rule 4.5 generally will be required to register as CPOs by the later of (i) December 31, 2012, or (ii) 60 days after the effective date of the final CFTC rulemaking defining the term “swap,” unless the operator is otherwise excluded from the definition of CPO or exempt from CPO registration.

1 Commodity Pool Operators and Commodity Trading Advisors: Amendments to Compliance Obligations; Final Rules, 77 Fed. Reg. 11252 (Feb. 24, 2012). The Adopting Release also amended several other CFTC rules. For more information regarding certain of these changes, see our client memoranda entitled “CFTC Eliminates Registration Exemption Used by Many Hedge Fund Managers” (the “4.13 Memo”) and “CFTC Adopts CPO and CTA Reporting Rules” (the “PQR Memo”), dated February 13, 2012 and February 17, 2012, respectively. 2 The CFTC has not adopted final rules further defining “swap” and other swap-related terms used in several CFTC and SEC proposed and final rulemakings that have been issued since the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub. L. No. 111-203, 124 Stat. 1376 (2010)) (the “Dodd- Frank Act”). See Proposed Interpretations: Further Definition of “Swap,” “Security-Based Swap,” “Security- Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping; Joint Proposed Rule, 76 Fed. Reg. 29818 (May 23, 2011). See also Proposed Interpretations: Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract Participant”; Joint Proposed Rule, 75 Fed. Reg. 80174 (Dec. 21, 2010). For more information about the latter proposal, please see our client memoranda entitled “Commodity Pools as ECPs after the Dodd- Frank Act,” “Proposed Definitions of Swap Dealer and Security-Based Swap Dealer” and “Proposed Definitions of Major Swap Participant and Major Security-Based Swap Participant,” dated February 2, 2011, February 14, 2011 and February 15, 2011, respectively.

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The Adopting Release further stated that the CPO registration requirements (and accompanying disclosure, recordkeeping and reporting requirements) will apply to advisers of RICs, rather than to the RICs themselves or their directors or trustees. Finally, the CFTC stated that the operators of RICs with wholly owned commodity-trading subsidiaries will be unable to rely on Rule 4.5 with respect to such subsidiaries.

To address some (though not all) of the conflicts between CFTC and SEC rules, the CFTC contemporaneously proposed rules to harmonize certain CFTC requirements with those of the SEC, to the extent the CFTC deemed appropriate (the “Harmonization Proposal”). 3 As proposed, the revised requirements would relieve advisers of RICs required to register as CPOs from the obligation to comply with many of the CFTC’s current recordkeeping, reporting and disclosure requirements that are otherwise applicable to registered CPOs. Such a CPO would not be required to comply with the revised requirements until 60 days after the effective date of the final harmonization rules. Comments on the Harmonization Proposal are due by April 24, 2012.

I. Rule 4.5: 2003 Amendment and the Proposal

In 2003, due primarily to the “otherwise-regulated” nature of RICs and the simultaneous adoption of CFTC Rule 4.13(a)(4), the CFTC adopted an amendment to Rule 4.5, eliminating certain trading and marketing limitations.4 Specifically, the 2003 amendment eliminated:

(i) the requirement that a RIC’s futures trading generally be limited to bona fide hedging; and

(ii) the restriction on marketing a RIC to the public as a commodity pool or other vehicle for trading in the commodity futures or options markets.

The Rule has remained unchanged since that time.

In a 2010 petition to the CFTC, the National Futures Association (“NFA”) expressed concern about certain RICs engaging in high levels of futures trading that were being offered and operated without CFTC regulation. Thereafter, the CFTC proposed to amend

3 Harmonization of Compliance Obligations for Registered Investment Companies Required to Register as Commodity Pool Operators; Proposed Rules, 77 Fed. Reg. 11345 (Feb. 24, 2012). 4 Additional Registration and Other Regulatory Relief for Commodity Pool Operators and Commodity Trading Advisors; Past Performance Issues; Final Rule, 68 Fed. Reg. 47221 (Aug. 8, 2003). Since 2003, CFTC Rule 4.13(a)(4) has provided an exemption from CPO registration for CPOs operating pools in which all the investors are sophisticated, as provided in that rule. Rule 4.13(a)(4) does not require that the CPO be subject to any other regulatory scheme and contains no restriction on the purpose or scope of the pool’s commodity interest trading. In light of the CPO registration relief the CFTC was providing to unregulated CPOs under the new Rule 4.13(a)(4), the CFTC believed that it was no longer necessary for “otherwise regulated” RICs to be subject to commodity interest trading restrictions in order to rely on Rule 4.5. The Adopting Release also rescinded Rule 4.13(a)(4), effective April 24, 2012. For more information, please see the 4.13 Memo.

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Rule 4.5 to reinstate restrictions on RICs trading futures (the “Proposal”).5 In addition to addressing the NFA’s concern, the Proposal cited several other reasons for amending Rule 4.5, including (i) to limit the possibility of entities engaging in regulatory arbitrage, (ii) to ensure consistent treatment of CPOs regardless of registration status with other regulators, and (iii) to ensure that the CPOs of de facto commodity pools are required to report the activities of such pools on the proposed Form CPO-PQR.6

II. Final Rule

The Final Rule was adopted substantially as proposed, with certain exceptions. These changes and other notable aspects of the Final Rule are discussed below.

A. Who Should Register?

The CFTC has taken the position that a RIC’s investment adviser is the appropriate entity to register as the RIC’s CPO. The CFTC noted that this approach would address the concern that a RIC’s independent directors or trustees may otherwise have been required to be listed as principals of the CPO and may themselves also have been required to register as CPOs under the amended Rule 4.5.7

B. The Five Percent Test and the Net Notional Test

The Final Rule reinstated the pre-2003 restriction on positions that do not qualify as bona fide hedges,8 as well as the exception to that restriction (the “Five Percent Test”). Prior to 2003, the Five Percent Test allowed a RIC to engage in speculative trading of commodity futures and options so long as the aggregate initial margin and premiums required to establish such positions did not exceed five percent of the liquidation value of the RIC’s portfolio. The reinstated Five Percent Test is similar to the pre-2003 version, with the exception that the initial

5 Commodity Pool Operators and Commodity Trading Advisors: Amendments to Compliance Obligations; Proposed Rule, 76 Fed. Reg. 7976, Feb. 11, 2011. For more information on the Proposal, please see our client memorandum dated February 28, 2011, entitled “SEC and CFTC Propose Private Fund Reporting Rules: Agencies Introduce New Forms PF, CPO-PQR and CTA-PR; CFTC Proposes to Limit Registration Exemptions” (the “Reporting Memo”). 6 For more information, please see the Reporting Memo and the PQR Memo. 7 Relieving a RIC’s independent directors/trustees from the requirement to register as CPOs is consistent with the recently adopted CFTC Rule 4.13(a)(5), which grants CPO registration relief to certain independent directors/trustees of commodity exchange-traded funds. Commodity Pool Operators: Relief From Compliance With Certain Disclosure, Reporting and Recordkeeping Requirements for Registered CPOs of Commodity Pools Listed for Trading on a National Securities Exchange; CPO Registration Exemption for Certain Independent Directors or Trustees of These Commodity Pools; Final Rules, 76 Fed. Reg. 28641 (May 18, 2011). For more information, please see our client memorandum dated May 26, 2011, entitled “CFTC Adopts Relief for Commodity ETFs” (the “ETF Memo”). 8 The Adopting Release stated that the CFTC does not consider a RIC’s “risk management” positions to be bona fide hedging positions.

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margin and premiums required to establish a RIC’s position in swaps must also now be included in the five percent calculation. This approach is consistent with the de minimis exemption from CPO registration available to CPOs under CFTC Rule 4.13(a)(3).9 Accordingly, any RIC that exceeds the Five Percent Test would have to be operated by a registered CPO that is subject to the CFTC’s and NFA’s full regulatory requirements (unless another exclusion or an exemption is available).

As an alternative to the Five Percent Test, the Final Rule also includes a new net notional value test (the “Net Notional Test”). That test will permit the adviser to rely on Rule 4.5 if the aggregate net notional value of the RIC’s non-hedging commodity futures, commodity options contracts, or swaps positions does not exceed 100 percent of the liquidation value of the RIC’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into.

The CFTC addressed the fact that the definition of “swap” is not yet finalized by stating in the Adopting Release that swaps need not be included in the five percent calculation until 60 days after such final rules become effective.10

C. Marketing Restriction

The marketing restriction, as proposed, would generally have prohibited unregistered commodity pool operators of RICs from marketing the RICs as commodity pools or as vehicles for trading in “or otherwise seeking investment exposure to” the commodity futures, commodity options or swaps markets. The Final Rule did not include the italicized language above because the CFTC was concerned such a provision might create uncertainty in the determination of whether a RIC was violating the marketing restriction.

Whether a RIC’s marketing materials violate the restriction on marketing the RIC as a commodity pool or as a vehicle for trading in the commodity futures, commodity options or swaps markets will be determined on a case-by-case basis by examination of all the relevant facts, and no single factor will be determinative. The Adopting Release listed seven non-exclusive factors that the CFTC deems indicative (though not dispositive) of marketing a RIC as a vehicle for investing in commodity futures, commodity options, or swaps:

9 CFTC Rule 4.13(a)(3) provides CPO registration relief to a CPO operating a pool offered to certain sophisticated investors that engages in only a de minimis amount of futures trading (initial margin and premiums are limited to five percent of the pool’s liquidation value). Although the Proposal also proposed to rescind Rule 4.13(a)(3) along with Rule 4.13(a)(4), the Adopting Release retained Rule 4.13(a)(3) with only minor revisions. For more information, please see the 4.13 Memo. 10 See note 3, above. Presumably, swaps may also be excluded from the net notional value calculation for purposes of the Net Notional Test until 60 days after the final rules defining “swap” become effective, although the Adopting Release was not explicit on this point.

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 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 controlled foreign corporation (“CFC”) 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 an entity on its behalf has a net short speculative exposure to any commodity through a direct or indirect investment in derivatives;  whether the futures/options/swaps 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; and  whether the fund is explicitly offering a managed futures strategy.

The CFTC noted that it will give the most weight to the final factor. The CFTC also noted that it will not consider the mere disclosure to investors or potential investors that the RIC may engage in derivatives trading incidental to its main investment strategy and the risks associated therewith as a violation of the marketing restriction.

D. Wholly Owned and Controlled Foreign Subsidiaries (a.k.a. CFCs)

The CFTC stated in the Adopting Release that operators of futures-trading and swaps-trading CFCs will be unable to rely on the amended Rule 4.5 with respect to such CFCs, and will be required to register as CPOs (unless another exclusion or an exemption is available).

To comply with certain federal tax requirements, RICs commonly use wholly owned and controlled foreign corporations to invest up to 25% of their assets in non-hedge commodity futures, options and swaps positions. The CFTC stated that it believes that such CFCs fall within the statutory definition of “commodity pool” and that their CPOs should be subject to CFTC regulation.11 To rely on the exclusion from the CPO definition in amended Rule 4.5, the operator must make certain representations with respect to a “qualifying entity” as defined in Rule 4.5. Futures-trading CFCs generally do not meet the definition of “qualifying entity.” As a result, the operators of such CFCs will generally be unable to rely on Rule 4.5 with respect to such CFCs.

11 This position conflicts with the common understanding among many practitioners that an entity with a single owner is not a pool.

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III. The Harmonization Proposal

Advisers to RICs that are required to register as CPOs due to the amendments to Rule 4.5 will be required to comply with the disclosure, reporting and recordkeeping requirements of both the CFTC and the SEC.12 There are several areas in which these regulatory regimes directly conflict. The Harmonization Proposal addresses some of these conflicts by proposing relief from certain CFTC requirements for CPOs of RICs. 13 Specific conflicts addressed in the Harmonization Proposal include:

 timing of disclosure document delivery;  disclosure document acknowledgements;  disclosure document update cycles;  timing of financial reporting to participants;  location of books and records;  disclosure of fees and past performance;  certification language; and  SEC-permitted use of a summary prospectus for open-end RICs.

Generally, the CFTC has proposed to amend CFTC Rule 4.12(c) to permit CPOs of RICs to claim the disclosure, reporting and recordkeeping relief currently available to the CPOs of commodity exchange-traded funds.14 With respect to performance disclosure, the CFTC proposed including the disclosure currently required by CFTC Rule 4.25 in the Statement of Additional Information that forms part of the RIC’s registration statement. In addition, the CFTC proposed to replace its nine-month disclosure document update cycle with a twelve-month cycle.15 The CFTC is soliciting comments on these changes as well as several others appearing in the Harmonization Proposal.

IV. The Registration Process

Advisers required to register as CPOs due to the amendments to Rule 4.5 must effect the registration through the NFA Online Registration System. Among other things, the CPO must (i) file an application and pay a registration fee and NFA membership dues for the CPO and (ii) file applications and fingerprint cards for the CPO’s principals and associated persons. In addition, associated persons must satisfy certain proficiency requirements (the Series 3 or certain other exams) unless an exemption is available.

12 Advisers of RICs that are required to register as CPOs due to the amendment of Rule 4.5 will be exempt from the current CFTC disclosure, recordkeeping and reporting requirements and will not be required to comply with the revised requirements until 60 days after final rules regarding such requirements become effective. 13 Certain portions of the proposed relief may also be made available to CPOs of pools whose units of participation are offered and sold pursuant to an effective registration statement under the Securities Act of 1933, as amended. 14 For more information, please see the ETF Memo. 15 This particular change, if adopted, will be applicable to all CPOs, not just CPOs of RICs.

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V. Annual Confirmation Requirements

The Final Rule also includes a new requirement that any CPO that has filed a notice of exclusion under Rule 4.5 to confirm such exclusion within 60 days of the end of each calendar year. Failure to comply with the annual affirmation requirement will be treated as a request to withdraw the notice of exclusion.

* * * * * * * * * * * * * * * If you have any questions concerning the foregoing or would like additional information, please contact Rita Molesworth (212-728-8727, [email protected]), Benjamin Haskin (202- 303-1124, [email protected]), Deborah Tuchman (212-728-8491, [email protected]), Gabriel Acri (212-728-8833, [email protected]), Jonathan Burwick (212-728-8108, [email protected]), James Lippert (212-728-8945, [email protected]), or the Willkie attorney with whom you regularly work.

Willkie Farr & Gallagher LLP is headquartered at 787 Seventh Avenue, New York, NY 10019- 6099 and has an office located at 1875 K Street, NW, Washington, D.C. 20006-1238. Our New York telephone number is (212) 728-8000 and our facsimile number is (212) 728-8111. Our Washington, D.C. telephone number is (202) 303-1000 and our facsimile number is (202) 303- 2000. Our website is located at www.willkie.com.

February 24, 2012

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