RIA Compliance Blog
The Commodities Future Trading Commission (CFTC) has adopted a final rule that makes several amendments to Regulation 4.5, which relates to commodity pool operators. The amendments add new limitations to an exclusion from the definition of a commodity pool operator (CPO) upon which registered investment companies have commonly relied. Currently, the rule excludes from the CPO definition entities that operate under other regulatory regimes, such as registered investment companies, banks, certain pension funds and insurance companies.
The amended regulations now impose two restrictions on registered investment companies that seek to use this exclusion. The first restriction is a trading threshold which would require an adviser to a registered investment company to either certify in a notice of eligibility filed with the NFT that it uses commodity futures, options or swaps only for “bona fide hedging purposes,” or, alternatively, that it meets one of the following two tests:
- Five percent test: In relation to positions in commodity futures, commodity option contracts or swaps, the aggregate initial margin and premiums required to establish those positions will not exceed five percent of the liquidation value of its portfolio, after taking into account unrealized profits and unrealized losses; or
- Net notional value test: the aggregate net notional value of commodity futures, commodity option contracts or swap position not solely used for “bona fide hedging purposes,” determined at the time the most recent position was established, does not exceed 100 percent of the liquidation value of the registered investment company’s portfolio, after taking into account unrealized profits and unrealized losses. The net notional value is calculated as described in CFTC Regulation 4.13(a)(ii)(B)(1) and 4.13(a)(ii)(B)(2).
The other requirement to be exempt from registration is a marketing restriction. Any adviser trying to use this exemption may not have been “marketing participants to the public as or in a commodity pool or otherwise as or in a vehicle for trading in the commodity futures, commodity options or swap markets.” The original proposal included a requirement that the adviser could not “otherwise seeking exposure to” commodities and swaps; however, this would have led to ambiguities so it was taken out for the final amendment. The CFTC lists a number of factors to determine whether an entity has violated this restriction. No single factor is considered dispositive. The factors include:
- 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 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 entity on its behalf has a net short speculative exposure to any commodity through a direct or indirect investment in other derivatives;
- Whether the futures, options or 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.
Please note that there is more weight given to the last factor when determining if a de facto commodity pool exists. Even if the firm does not manage futures strategy, it may still not be eligible for the exemption because it satisfies a number of other factors on the list.
The amendments have a few other effects. Advisers who now have to register as a CPO will have to file Form 7-R online, pay a fee of $200 and pay CPO membership dues of $750. All associated person who solicit or accept orders, discretionary accounts or participate in a commodity pool on behalf of a CPO will also have to register. Wholly-owned subsidiaries also known as controlled foreign corporations are now subject to registration. Also, those firms who remain eligible for the exemption will have to file a form annually claiming it as opposed to the one time notice that is currently required.
Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds and issuers of securities, among others. Our regulatory practice group assists financial service providers with the complex issues that arise in the course of their businesses, including compliance with federal and state laws and rules.