G Hedge Fund Alert August 1998 What If You Use Futures In Your Trading Strategy? By: George J. Mazin, Esq.

are some notable exceptions described below, in ne of the first questions new managers general, a fund which engages in the trading of should consider is whether futures will commodity interests (however incidental the be used as a part of the manager’s trading may be) is a commodity pool and the Otrading strategy. If the answer is yes, the hedge manager of that fund is a commodity pool operator, fund manager will likely become subject to the subject to the registration requirements of the Act. comprehensive regulatory regime administered by For a domestic partnership, the general partner of the Commodity Futures Trading Commission the partnership is the commodity pool operator and (“CFTC”) and the National Futures Association is required to register in this capacity. In the case of (“NFA”). This regime imposes a host of an offshore fund, if the investment manager is in regulatory responsibilities on the manager, the United States and trades commodity interests including testing, ethics training, disclosure on U.S. commodity exchanges, the investment obligations, and accounting and reporting manager will generally be required to register as a requirements. The manager also becomes subject commodity trading advisor. to the anti-fraud provisions of the Commodity Exchange Act. A brief presentation, such as this In addition to the registration requirements Alert, cannot present all material aspects of the applicable to the general partner, the members or commodities laws. It does, however, outline some partners of the general partner will be required to of the more important requirements of which a register as principals of the commodity pool manager must be aware. operator or commodity trading advisor. Other Who Must Register? employees involved in making trading decisions with respect to futures or soliciting investors will generally be required to register as associated A person may not operate a commodity persons. pool unless registered as a commodity pool operator. The Commodity Exchange Act (the As part of the process, all persons applying “Act”) broadly defines a commodity pool operator for registration will be required to pass the Series 3 as “a person engaged in a business that is in the exam. The CFTC has delegated to the NFA nature of an investment trust, syndicate or similar (which is a self-regulatory organization) authority form of enterprise, and who, in connection to regulate the managed futures industry. The NFA therewith, solicits, accepts or receives from others has been willing to waive the examination funds . . .for the purpose of trading in any requirement under a variety of circumstances. In a commodity. .” The starting point in the analysis published interpretive notice, the NFA has stated of whether a manager is a commodity pool that in the case of a fund that engages principally in operator is to determine whether the fund or securities transactions, which commits only a small other pooled investment vehicle managed by that percentage of its assets as initial margin for futures manager is a “commodity pool.” Although there This document is published by Lowenstein Sandler PC to keep clients and friends informed about current issues. It is intended to provide general information only.

Roseland, New Jersey Telephone 973.597.2500 65 Livingston Avenue www.lowenstein.com 07068-1791 L Fax 973.597.2400 G and options on futures and uses futures $200,000 in capital and fewer than 15 participants transactions and options solely for hedging or risk need not register. management purposes, the NFA is authorized to waive the exam requirement. In addition, for In recent years, requests have been made to funds which do not limit their use of futures solely the CFTC seeking no action relief for hedge funds for hedging or risk management purposes, a waiver that engage primarily in the trading of securities, of the exam may be available if there is at least one which use futures on an infrequent basis and which registered principal who has taken and passed the commit a de minimis portion of the fund’s net assets examination and the person requesting the waiver as margin for commodity positions. Although is not involved in marketing interests in the fund several years ago it appeared that the staff of the or making investment decisions concerning the CFTC was prepared to provide relief to funds that use of futures. committed less than five percent of their net assets as margin for commodity positions, more recently, Is There An Exemption Available? the staff has indicated that under current Rules, the appropriate avenue for obtaining a de minimis Before initiating the registration process, it exemption is through a petition for rule making. is worth exploring whether an exemption from the registration requirements may be available. Perhaps in response to this suggestion, on Through a combination of exemptions formally June 5, 1998 the NFA submitted a Petition For Rule adopted by regulation and others created through Making. In its Petition, the NFA is seeking to administrative interpretation, several options may amend Rule 4.12 in order to exempt managers of be available. hedge funds from commodity pool operator registration if they operate only vehicles that do a de First, there are a limited number of minimis amount of futures transactions. To qualify circumstances in which the CFTC has concluded for the exemption, the aggregate initial margin that a trading vehicle was not a commodity pool premiums required to establish futures positions for within the meaning or intent of the Rules. These any pool may not exceed five percent of the cases generally involve investment vehicles in liquidation value of the pool’s portfolio, after taking which participation is limited to family members, into account unrealized profits and unrealized losses several close personal and business associates of on any such contracts. Additional requirements the manager, and individuals otherwise actively which would have to be satisfied in order to qualify involved in the business of the fund. This for the proposed exemption are that the pool may exemption is obviously of limited utility since it is not market participations to the public as a vehicle available only to funds with a very limited number for trading in the commodity futures or commodity of investors and which do not intend to solicit options markets, the applicable offering additional investors. memorandum must disclose to prospective participants the purposes of and the limitations on Section 4.13 of the Rules provides two the scope of the commodity futures trading in which alternative but similar bases for an exemption. If the pool will engage and a statement must be the general partner does not receive any provided to each prospective participant and filed compensation for managing the fund, it operates with the CFTC advising prospective participants only one pool and is not otherwise required to that the manager is not registered as a commodity register with the CFTC by virtue of other pool operator. Managers relying upon this affiliations that the general partner or its principals exemption would nevertheless remain subject to the may have, such person is exempt from the anti-fraud rules of the Commodity Exchange Act. requirement to register as a commodity pool operator. Alternatively, a fund with less than G

In proposing the rule change, the NFA addition, both the quarterly account statements and indicated that the purpose of the change is to free annual financial statements need not strictly up NFA’s resources to better regulate and audit comply with CFTC requirements. firms that are more directly involved in the futures markets. The Petition recognized that hedge funds A Section 4.7 exempt pool is not limited in which do not commit more than a de minimis the percentage of its assets which may be committed portion of their assets as margin for commodity as margin for commodity interest transactions. futures positions and which do not market However, each investor in the fund must be a themselves to the public as vehicles for qualified eligible participant (“QEP”). The QEP participating in the futures markets do not merit definition is complex, particularly as applied to the amount of regulatory resources which are investors which are not natural persons and imposes currently being dedicated to the hedge fund a higher eligibility threshold on investors than industry. While it is premature to predict whether would otherwise be applicable to a Regulation D the CFTC will adopt the change as proposed, if private placement. In the case of a natural person, adopted, it will clearly provide significant benefits the investor must: to the hedge fund community. z be an accredited investor ($1 million net Unless and until this proposal is adopted, worth, or a minimum annual income of managers will have to rely on several less $200,000 in each of the two most recent years, comprehensive exemptions. Under existing or joint income with that person’s spouse in Section 4.12(b), an exemption is available to a excess of $300,000 with a reasonable fund which does not commit more than ten expectation of reaching the same income level percent of the fair market value of its assets as in the current year) margin for commodity positions and which trades z own securities having a market value of at least commodity interests in a manner solely incidental $2 million, or $200,000 on deposit with a to its securities trading activities. The relief futures commission merchant in exchange available to a fund which relies upon this specified initial margin and option premiums exemption is quite limited. The disclosure for commodity interest transactions, or a document for a 4.12(b) pool need not include the combination of the two. prior performance of the pool, account statements may be provided quarterly, rather than monthly, The QEP definition becomes especially and the annual financial statements need not complex in the case of a fund-of-funds investor. strictly comply in all respects with the CFTC’s The fund-of-funds must: requirements as to format and presentation. z satisfy the $2 million/$200,000 requirement Far more useful is the exemption available and must have assets in excess of $5 million pursuant to Section 4.7 of the Rules. A fund z be able to represent that either the aggregate which qualifies for the exemption afforded by investment by the fund-of-funds in all 4.7 Section 4.7 is not required to submit a disclosure exempt pools does not exceed ten percent of document to the CFTC or NFA for review before the fair market value of the assets of the fund- offering interests in the fund to prospective of-funds, or each of the investors in the fund- participants. In addition, if a disclosure document of-funds must be a QEP. is utilized, it need not strictly comply with CFTC disclosure requirements, although the offering is Non-U.S. persons generally qualify as QEPs ultimately subject to the CFTC anti-fraud rules. In without regard to the other tests. However, in the case of an offshore fund, if participation in the fund G by U.S. persons exceeds ten percent of the net this premise, the manager of a fund-of-funds is assets of the fund, it will not qualify as a non-U.S. required to provide extensive information person. concerning the underlying managers with which the fund intends to invest and the strategies employed. What About The Disclosure Document? At a minimum, the fund must identify:

One of the more onerous requirements z the approximate percentage of the pool’s assets associated with being regulated as a commodity that will be allocated to different strategies; pool is the obligation to prepare and provide to z the types of securities which will be traded by prospective investors a disclosure document which the managers; and complies with CFTC requirements. CFTC Rules specify in considerable detail the nature and scope z a description of the trading and investment of the disclosure which must be provided to programs and policies which will be followed by the fund, including any material restrictions on investors. A significant portion of the required trading. disclosure consists of information which would not otherwise be found in the offering memorandum if For any manager which is “a major investee it was prepared for a fund which does not trade pool,” i.e., an underlying fund in which the fund-of- commodity interests. funds intends to invest more than ten percent of its net assets, additional disclosure is required, Absent a 4.7 exemption, commodity pool including information concerning volatility, disclosure documents must contain, among other leverage, rates of return and length of time during things, certain specified legends and a break-even which the manager has employed the strategy. In analysis. The break-even analysis is a tabular addition, a five-year business background must be presentation of the hypothetical amount of income provided for each principal of a major investee pool. and gain the pool would have to generate over 12 If during the course of a year significant changes are months in order to offset all expenses allocable or made in a fund’s asset allocation which results in an chargeable to the investor and enable the investor investee pool becoming a major investee pool, or in to recoup its initial investment upon withdrawal. a pool which was disclosed as a major investee pool The break-even analysis requires the manager to falling below ten percent so that it is no longer a disclose every expense of the fund and to present major investee pool, the offering document may the assumptions utilized in determining the break- become misleading and must be promptly amended. even point. Often troubling to the hedge fund manager is the CFTC requirement that trading One of the anomalies of the regulatory commissions be treated as an expense and scheme is that the term “major investee pool” included in the fund’s expense ratio. applies only to an underlying fund which is itself a commodity pool. Because the CFTC does not have CFTC disclosure requirements are jurisdiction over underlying funds which do not especially problematic for a fund-of-funds. A employ commodities, the CFTC cannot compel a fund-of-funds is marketed by its manager on the fund-of-funds to provide comparable disclosure basis that investors are investing in reliance upon about an investment in a fund over which it does the general partner’s ability to select managers and not otherwise have jurisdiction. Therefore, it is to make periodic changes in the allocation of the possible to have a disclosure document which has fund’s assets among managers. Notwithstanding extensive disclosure concerning a fund in which the G fund-of-funds has invested a relatively small Past performance, if provided to investors, must portion of its assets, but very limited information be disclosed in the format mandated by CFTC Rules. about a securities partnership in which the fund has In general, the rate of return must be provided on a invested significantly more than ten percent of its monthly basis for five full years and year-to-date. All assets. performance must be presented net of all fees, Unless a fund intends to rely upon a 4.7 expenses and performance allocations. The largest exemption, the disclosure document must be monthly draw down during the five-year period and submitted to and approved by the NFA before the year-to-date and the worst “peak-to-valley” draw fund may accept subscriptions from investors. A down during the same five-year period and year-to- new fund being organized must factor this review date must also be disclosed. In the case of a fund period into its timing in establishing an expected which has less than a three-year operating history, launch date for the fund. In addition, offering the general partner must generally disclose the materials must be updated no less frequently than performance of any other pool operated by the once every nine months. At the time of each general partner during the relevant five-year period. updating, the revised offering materials must be In addition, fund-of-funds managers should be aware resubmitted to the NFA for its approval. that the performance of any major investee pool (a fund which is a commodity pool in which the fund Beware Of Other Requirements has invested ten percent or more of its assets) must be presented in the disclosure document in Registered commodity pool operators are accordance with the same rules. also subject to the accounting, recordkeeping and reporting requirements found in the Commodity For new funds which do not yet have any Pool Rules. Among the more significant performance history, the general partner may hope to requirements is an obligation to provide quarterly use hypothetical past performance. While not (or monthly in the case of a pool which does not prohibited, the use of hypothetical performance obtain a Section 4.12(b) or Section 4.7 exemption) information is strongly discouraged by the NFA account statements to all investors. The account because of its potential to be misleading to statements must be in a format which is somewhat prospective investors. As a result, it must be different than the format ordinarily used by a presented in compliance with several NFA releases securities partnership. In addition, audited which have been issued on this subject. Among financial statements must be filed with the CFTC other things, the releases mandate the disclosure on an annual basis and provided to each investor. which must be presented in order to describe the A fund-of-funds is in a constant tug-of-war with manner in which the performance has been the CFTC because of the requirement that audited determined, including the assumptions used. financial statements be provided to pool Certain legends must be prominently displayed to participants and filed with the CFTC within 90 highlight the limitations of hypothetical performance days of the end of the fund’s fiscal year. Because a information. fund-of-funds cannot complete its audit until it A final burden associated with being receives audited financials from each of its registered as a commodity pool operator is the need underlying funds, a fund-of-funds will often require to undergo periodic examinations by NFA up to 180 days to complete its audit. examiners. At best, examinations are time consuming and anxiety producing. G

To Register Or Not To Register

When confronted with the responsibilities imposed upon a registered commodity pool operator, a manager may find the obligations to be daunting. Instead of registering, the manager may conclude that instruments which are not regulated by the CFTC (such as index options) can be an effective surrogate for the use of futures. For those who opt for registration, problems can best be avoided by preparing for the process by designating a principal of the firm to assume responsibility for ongoing compliance and ensuring that the person designated familiarizes himself or herself with the requirements. If you have any questions regarding this or any other investment management issue, please call George J. Mazin, Chair of the Investment Management Practice Group, at (973) 597-2500.