CFTC Rule 4.5 Amendments Implications for Registered Investment Companies

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1 CFTC Rule 4.5 Amendments Implications for Registered Investment Companies Presentation to the Mutual Funds Directors Forum Rose DiMartino and Ben Haskin Willkie Farr & Gallagher LLP May 31, 2012

2 Overview of CFTC Releases On February 9, 2012, the CFTC voted 4-1 to adopt final rules that, among other things, amend CFTC Rule 4.5 to rescind the exemption from registration for commodity pool operators ( CPOs ) of certain investment companies registered under the Investment Company Act of 1940 (the 1940 Act ). CPOs of certain registered investment companies ( RICs ) that invest in commodity futures, commodity options or swaps for purposes other than bona fide hedging will not be able to rely upon amended Rule 4.5 for exemption from registration with the CFTC. In order to reconcile conflicting CFTC and SEC disclosure, reporting and recordkeeping requirements, the CFTC voted 5-0 to propose amendments to its regulations regarding RICs whose registered investment advisers ( RIAs ) will be subject to registration as CPOs under amended Rule

3 Who must register as a CPO? The investment adviser to a RIC that can no longer rely on Rule 4.5 and not the Board of the RIC must register as a CPO. This is significant because, under current practice, if a commodity pool is structured as a corporation or other legal entity with a board of directors/trustees, the directors/trustees of the commodity pool would be required to register as CPOs. In practice, most commodity pools are structured as either LPs or LLCs. The general partner or managing member, as applicable, registers as the CPO. 3

4 Who can rely on amended Rule 4.5? In order to rely on amended Rule 4.5, a RIC must qualify for exemption under a Trading Test and a Marketing Test. Trading Test Alternative 1: The RIC may not trade commodity futures, options and swaps in an amount such that initial margin payments exceed 5% of the liquidation value of the RIC. Alternative 2: The RIC may limit use of commodity futures, options and swaps to meet a net notional test. Bona fide hedging transactions are excluded from both trading alternatives. Marketing Test A RIC also must not market itself as a commodity pool or as a vehicle for trading in the commodity futures, commodity options, or swaps markets. 4

5 Alternative 1: 5% Threshold Restriction for Trading Commodity Futures, Options and Swaps Commodity futures defined broadly: includes broad-based stock index futures (e.g., S&P 500 futures), security futures generally and financial futures contracts as a whole. The CFTC takes the position that Section 2 of the Commodity Exchange Act ( CEA ) grants the CFTC authority over all futures. Dodd-Frank sweeps in swaps: The Dodd-Frank Act amended the statutory definition of the terms commodity pool operator and commodity pool to include those entities that trade swaps. CPOs of certain RICs that invest in swaps based on similar reference assets may also not be able to rely on amended Rule 4.5. The CFTC will not implement the final rules, including the inclusion of swaps within the 5% threshold test, until 60 days after the final rules regarding the definition of swap and the delineation of the margin requirement for such instruments are effective. 5

6 Alternative 2: Net Notional Test RICs may also rely on amended Rule 4.5 if the aggregate net notional value of the RIC s commodity interest positions do not exceed 100% of the liquidation value of the RIC s portfolio. Notional value is defined by asset class. Futures Notional value is derived by multiplying the number of contracts by the size of the contract, in contract units, and then multiplying by the current market price for the contract. Swaps Notional value will be determined consistent with the provisions of Part 45 of the CFTC s regulations. Ability to net positions is determined by asset class. Futures Net across designated contract markets or foreign boards of trade. Swaps May only be netted if cleared by the same designated clearing organization and if it is otherwise appropriate. 6

7 Bona Fide Hedging Bona fide hedging is defined in CFTC Rule 1.3(z)(1) to constitute commodity interest positions that: normally represent a substitute for... positions to be taken at a later time in a physical marketing channel ; are economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise ; arise from the potential change in the value of the RIC s assets or liabilities, or services; are for the purpose of [offsetting] price risks incidental to commercial cash or spot operations ; and comply with relevant trading and position limit requirements. The CFTC may recognize transactions and positions as bona fide hedging in such amounts and under such terms and conditions as it may specify. 7

8 Bona Fide Hedging The CFTC divides the use of futures into bona fide hedging or speculative transactions. Bona fide hedging No position limits Lower margin Speculative Position limits Higher margin 8

9 Bona Fide Hedging According to the CFTC final rule release: Risk management transactions do not constitute bona fide hedging. An important distinction between bona fide hedging transactions and those undertaken for risk management purposes is that bona fide hedging transactions are unlikely to present the same level of market risk as they are offset by exposure in the physical markets. But the Chicago Mercantile Exchange ( CME ) has provided exemptions from speculative position limits on certain contracts for bona fide hedging purposes, including an exemption to a hedge fund manager with respect to S&P 500 Index futures and options contracts. 9

10 Marketing Restriction The CFTC believes that the following factors are indicative of marketing a RIC as a vehicle for investing in commodity futures, commodity options or swaps: 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 ) (e.g., a Cayman subsidiary) 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 CFC has a net short speculative exposure to any commodity through a direct or indirect investment in other derivatives; Whether the futures/options/swaps transactions engaged in by the fund or CFC will directly or indirectly be the fund s primary source of potential gains and losses; and Whether the fund is explicitly offering a managed futures strategy. 10

11 Marketing Restriction No single factor is dispositive. The factors identified by the CFTC are not a safe harbor. The CFTC will give more weight to whether the fund is explicitly offering a managed futures strategy when determining whether a RIC is operating as a de facto commodity pool. The CFTC will not consider the mere disclosure to investors that the RIC may engage in derivatives trading incidental to its main investment strategy and the risks associated therewith as being violative of the marketing restriction. 11

12 Harmonization of SEC and CFTC Compliance Obligations The CFTC simultaneously proposed rules meant to harmonize the conflicting SEC and CFTC disclosure, reporting and recordkeeping requirements when it adopted the amendments to Rule 4.5. Entities that must register as CPOs due to the amendments to Rule 4.5 are not required to comply with CPO recordkeeping, reporting and disclosure requirements until the adoption of a final rule governing the compliance framework for RICs subject to CFTC jurisdiction. As a result, investment advisers of RICs may become subject to regulation as CPOs before the revised recordkeeping, reporting and disclosure requirements go into effect. 12

13 Harmonization of SEC and CFTC Compliance Obligations There are numerous inconsistencies between the SEC and CFTC regulatory structures. Inconsistencies include: Differing disclosure requirements, including related performance and fee disclosure. CFTC requirement to acknowledge receipt of disclosure document. Differing recordkeeping requirements. Differing regulatory review of disclosure documents. 13

14 Distribution of a RIC that cannot rely on Rule 4.5 Associated persons of a CPO or Commodity Trading Advisor ( CTA ) must hold a Series 3 license, unless otherwise exempt by the CFTC or National Futures Association ( NFA ). Associated person means, in relevant part, any natural person who is associated as a partner, officer, employee, consultant or agent (or occupying a similar status or performing similar functions) in any capacity with a: CPO which involves: The solicitation of funds, securities, or property for a participation in a commodity pool; or The supervision of any person or persons so engaged. CTA which involves: The solicitation of a client s or prospective client s discretionary account; or The supervision of any person or persons so engaged. A person is exempt from registration as an associated person (i.e., is not required to obtain a Series 3 license) if the person already holds a Series 6 or a Series 7 license, unless the person is engaged in activity otherwise regulated by the CFTC. See CFTC Rule 3.12(h)(1)(ii). 14

15 Cayman Subsidiary The CFTC stated in the release amending Rule 4.5 that the wholly-owned Cayman subsidiaries of RICs fall within the statutory definition of commodity pool and should be subject to regulation as a commodity pool. The CFTC does not oppose the use of Cayman subsidiaries for trading in commodity interests by RICs, but such Cayman subsidiaries will be required to have their CPOs register with the CFTC unless otherwise exempted. 15

16 Who is the CPO of a Cayman subsidiary? The final rule release provides that the investment adviser of a RIC may register as a CPO, but does not provide similar guidance for Cayman subsidiaries. If the CFTC does not exempt directors of Cayman subsidiaries from the registration requirements, the directors of the Cayman subsidiary may be required to register as CPOs with the CFTC unless delegation to the adviser is permissible. 16

17 Implications for Registered Fund of Funds The CFTC releases are silent on whether a registered fund of funds, that invests in a RIC that cannot rely on the exemption in amended Rule 4.5, will be able to rely on amended Rule 4.5 in the aggregate so that the registered fund of funds investment adviser will not have to register as a CPO. As a result, it is currently unclear whether an adviser to a registered fund of funds that invests in a RIC that cannot rely on the exemption in amended Rule 4.5 will have to register as a CPO. A fact-specific analysis under Rule 4.5 would be necessary. 17

18 Implications for New Funds Absent additional guidance, the CPO of a Cayman subsidiary of a RIC that is formed after April 24, 2012 may have to register as a CPO and comply with all CPO reporting requirements immediately unless an exemption is available. 18

19 ICI and Chamber File Complaint Against the CFTC The Investment Company Institute and the U.S. Chamber of Commerce have filed a complaint against the CFTC in the U.S. District Court for the District of Columbia. Complaint makes claims under the CEA and the Administrative Procedure Act ( APA ). The lawsuit: Challenges, among other things, the CFTC s cost-benefit analysis; Argues that CFTC registration is redundant because the SEC already regulates registered investment companies; Requests the court to declare that the amendments to Rule 4.5 are arbitrary and capricious under the APA; and Asks the court to vacate and set aside the amendments to Rule 4.5 and seeks injunctive relief in connection therewith to prevent the CFTC from implementing the amendments to Rule 4.5. The ICI and the Chamber filed a summary judgment motion on May 18, Argues that the amendments to Rule 4.5 are arbitrary and capricious, fail to comply with the cost-benefit provisions of the CEA, and should be vacated. 19

20 Important Dates Effective Date of Amended Rule 4.5 April 24, 2012 Compliance deadline with CPO registration requirements Later of December 31, 2012 or 60 days after the effective date of the final CFTC rulemaking further defining swap CFTC rulemaking further defining swap is expected to be completed in 2012 Compliance deadline with CPO recordkeeping, reporting and disclosure requirements 60 days after effectiveness of final rules implementing the CFTC s proposed harmonization rulemaking If the harmonization rules are not effective on December 31, 2012, the CPO of a RIC will initially only be subject to CFTC rules other than recordkeeping, reporting and disclosure rules until harmonization rules are adopted 20