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.