Many Hedge Funds May Now Invest in Futures Without CPO or CTA Registration
March 31, 2004
BACKGROUND
On August 8, 2003, the Commodity Futures Trading Commission (the “CFTC”) amended its rules under the Commodity Exchange Act (the “Commodity Act”) to provide registration relief for certain commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”). The amended rules significantly reduce the scope of commodity pool regulation by adding two broad exemptions from CPO registration.
Generally, a CPO who is registered, or who is required to be registered, is required to deliver a disclosure document to prospective participants in the pool, to distribute periodic account statements and an annual report to participants and to make and keep specified books and records. Similarly, a CTA having discretionary trading authority who is registered, or who is required to be registered, is required to deliver a disclosure document to prospective clients describing its trading program and to make and keep specified books and records. Previously, the CFTC declined to provide an exemption from CPO registration for hedge fund managers (“Managers”) who committed only a limited amount of their managed assets to trading in commodity interests. Consequently, most Managers were either required to register as CPOs and/or CTAs or refrain from investing hedge fund assets in futures.
The amendments to the CFTC’s rules provide greater regulatory relief for Managers and facilitate increased use of the commodities markets by eliminating unnecessary or duplicative regulatory burdens. Now, under amended Rule 4.13, many hedge funds will be eligible to trade at least a limited amount of futures without registration. In addition, funds that limit their offerings to certain sophisticated investors will be able to trade futures without limitation and without having to have their Managers register as CPOs. The amended rules also add a new exception from CTA registration for persons providing advice to commodity pools that meet the requirements of the new CPO registration exemptions discussed above
CPO REGISTRATION EXEMPTIONS UNDER RULE 4.13
A. Rule 4.13(a)(3)—The “Limited Trading” Exemption
Rule 4.13(a)(3), based on a pool’s limited commodity interest trading, exempts a Manager from registration as a CPO if:
(i) sale of interests in the fund is exempt from registration under the Securities Act of 1933 (the “Securities Act”) and the interests are not marketed to the public in the U.S.;
(ii) the CPO reasonably believes that each investor in the fund is either:
• an “accredited investor” (as defined in Rule 501(a) of Regulation D under the Securities Act (“Regulation D”));
• a “knowledgeable employee” (as defined in Rule 3c-5 of the Investment Company Act of 1940 (the “Investment Company Act”));
• a trust formed by an accredited investor for the benefit of a family member; or
• a non-U.S. person, a “qualified purchaser” as defined in Section 2(a)(51)(A) of the Investment Company Act or another type of “qualified eligible person” (“QEP”) (as defined in CFTC Rule 4.7(a)(2)(viii)(A)); [1] [2]
(iii) participations in the fund are not marketed as a vehicle to trade commodity interests; and
(iv) the fund does not (when directly investing in commodities):
• commit more than 5% of its assets to establish commodity interest positions; or
• have commodity interest positions with a notional value that exceeds 100% of the fund’s liquidation value.
Most hedge funds will have no difficulty complying with requirements (i) and (ii) above. Thus, for most hedge funds the ability to rely on the new exemption will depend on the extent to which they intend to invest in futures and other commodity interests, whether as a hedge against their securities portfolios or otherwise, and whether or not they market themselves as commodity pools. If a hedge fund does not market itself as a commodity pool, the volume limitations alone will determine whether its Manager is exempt from the CPO registration requirements
The exemption provides two alternative tests to determine whether the amount of commodity interests is limited. First, the aggregate initial margin and premiums required to establish such positions, determined at the time the most recent position was established, cannot exceed five-percent (5%) of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into.
Alternatively, the aggregate net notional value of such positions, determined at the time the most recent position was established, cannot exceed one-hundred percent (100%) of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into.
In addition, the CFTC has amended the Rule 4.13 exemption from registration for small pools with no more than 15 investors to increase the asset limit from $200,000 to $400,000.
The amended Rules also clarify how a fund-of-funds [3] may use the new Limited Trading Exemption provided by Rule 4.13(a)(3). Although the CFTC did not adopt a precise rule as to when the Manager of a fund-of-funds would be eligible for the new exemption, it did adopt Appendix A to Part 4 of its Regulations (“Appendix A”), which includes several hypothetical situations that illustrate when such a Manager would be eligible for exemption. Assuming the fund-of-funds complies with all of the other requirements of Rule 4.13(a)(3) set forth in clauses (i), (ii) and (iii) above, Appendix A provides that a Manager of a fund-of-funds that invests in a commodity pool may claim exemption from the CPO registration requirement if:
(a) the CPO of each underlying fund is claiming an exemption from CPO registration, or is registered and complying with all of the trading restrictions set forth in Rule 4.13(a)(3) above; [4] or
(b) the CPO of the fund of funds has actual knowledge of the commodity interest trading positions of the underlying funds (e.g., where the investee funds are operated by the CPO or one of more affiliates of the CPO); [5] or
(c) the fund of funds has allocated no more than 50% of its assets to the underlying funds that trade commodity interests and does not trade commodity interests directly (regardless of the level of commodity interest trading engaged in by the underlying funds). [6]
If a fund of funds invests directly in commodity interests in addition to allocating assets to underlying funds, it must treat such directly traded portions of the fund as a separate pool, subject to the trading limitations set forth above in clause (iv), in order to claim an exemption.
It should be noted, however, that because the general guidelines and hypothetical situations discussed in Appendix A do not provide absolute certainty as to the availability of the Rule 4.13(a)(3) exemption for Managers of fund-of-funds, the CFTC encourages such Managers to contact the CFTC to discuss whether exemption would be appropriate in their particular circumstances.
B. Rule 4.13(a)(4)—The “Sophisticated Investor” Exemption
Rule 4.13(a)(4), based on the sophistication of a pool’s investors, exempts a Manager from CPO registration where:
(i) interests in the fund or pool for which the Manager seeks to claim relief are exempt from registration under the Securities Act and are not marketed to the public in the U.S.; and
(ii) the CPO reasonably believes that participation in the pool is limited to:
(a) natural persons that are:
• QEPs of the type not required to meet the minimum investment portfolio requirements described in footnote 2, above (such as non-U.S. persons and qualified purchasers); and
(b) non-natural persons (i.e., entities) that are either:
• QEPs (which includes non-U.S. persons); or
• accredited investors as defined in Regulation D.
The principal difference between the Limited Trading Exemption and the Sophisticated Investor Exemption is that the latter does not require the Manager to limit the hedge fund’s investments in commodity interest positions. So-called 3c7 Funds (those hedge funds in which participation is limited to qualified purchasers) and offshore funds in which participation is limited to non-U.S. persons and U.S. tax-exempt entities that are accredited investors are obvious beneficiaries of the more liberal Sophisticated Investor Exemption.
A CPO may operate one or more pools under either exemption and may also operate additional pools on a regulated basis.
A CPO of a fund of funds which is eligible to claim the Sophisticated Trading Exemption may invest without restriction as to the futures activity of the investee funds.
C. Qualifying for an Exemption from the CPO Registration Requirements
To qualify for either exemption, a CPO must file a notice with the National Futures Association (the “NFA”) [7] and notify prospective pool participants (i.e., hedge fund investors) of its exempt status. A CPO who currently operates pools on a regulated basis and wishes to rely on one of the new exemptions going forward must notify the pool participants that it intends to withdraw from registration, provide certain specified disclosures and provide each participant with an opportunity to redeem its interest. This is discussed further, below.
CTA REGISTRATION EXEMPTIONS UNDER RULE 4.14
A. Rule 4.14(a)(8)—Exemption Where Advice is Given Solely to Pools Exempt Under Rules 4.13(a)(3) and 4.13(a)(4)
Amended Rule 4.14(a)(8) provides an exemption from CTA registration for persons providing advice solely to commodity pools whose operators are exempt pursuant to one of the new CPO registration exemptions discussed above. Under this exemption, a registered securities investment adviser (whether with the Securities and Exchange Commission (“SEC”) or any State), or a person who is exempt from such registration or who is excluded from the definition of the term “investment adviser” under the Investment Advisers Act of 1940 (the “Investment Advisers Act”), such as banks and attorneys, is permitted to provide commodity interest trading advice solely incidental to its business of providing securities or other investment advice to such entities, if (1) it does not otherwise hold itself out as a CTA, and (2) files a notice of exemption from CTA registration with the NFA.
Most hedge fund managers will have little difficulty claiming this exemption from the CFTC’s CTA registration requirements.
B. Rule 4.10(a)(10)—Counting Entities as a Single “Person”
The CFTC also added new Rule 4.14(a)(10), which treats as one person, for purposes of the exemption from CTA registration in Section 4m(1) of the Commodity Act, limited partnerships and other collective investment vehicles that receive trading advice based upon their investment objectives rather than the individual investment objectives of their beneficial owners. Section 4m(1) of the Commodity Act exempts any person from registration as a CTA who, during any twelve month period, does not furnish commodity trading advice to more than fifteen persons and who does not hold himself out generally to the public as a CTA. The new rule is patterned after the SEC’s “single client” regulation (Rule 203(b)(3) under the Investment Advisers Act). For this purpose, the Commission intends generally to follow interpretations of Rule 203(b)(3) issued by the SEC and its staff. [8] Consistent with Rule 203(b)(3), Rule 4.14(a)(10) provides that an advisor relying on this provision will not be deemed to be holding itself out generally to the public as a CTA within the meaning of Section 4m(1) of the Act solely because it participates in a non-public offering of interests in a collective investment vehicle under the Securities Act.
The adoption of Rule 4.14(a)(10) represents a significant change in the traditional approach taken by the CFTC on this issue. Previously, the CFTC’s approach was to “look through” a passive investment vehicle and count each of its beneficial owners as “persons” for purposes of the Section 4m(1) exemption from registration. In addition, the CFTC traditionally held the view that an advisor to such a vehicle was holding itself out generally to the public as a CTA by reason of participating in a non- public offering of interests in such a fund.
Under Section 4m(1) of the Commodity Act and new Rule 4.14(a)(10), an investment adviser may, without having to register as a CTA, provide commodity trading advice to up to 15 privately offered commodity pools (assuming that it has no other clients to whom it renders advice), provided the advice is based upon the investment objectives of each pool, rather than those of its individual participants. The CFTC’s action, therefore, significantly enhances the usefulness of this particular exemption, especially for investment advisers relying on the analogous fewer than 15 client exemption from registration with the SEC provided by the Investment Advisers Act.
FILING OF NOTICE REQUIRED TO CLAIM EXEMPTIONS
The exemptions available under the amended Rules are not self-executing. Every Manager claiming an exemption under the Rules must file a Notice of Exemption (the “Notice”) with the NFA requesting exemption from registration. In addition, in the case of a CPO, disclosure of the exemption from registration, in the form prescribed by the CFTC, must be made to each prospective investor in the pool not later than the time of delivery of subscription agreements for such pool to the prospective investors.
The Notice must be filed no later than the time (1) the CPO delivers a subscription agreement for the pool to a prospective investor, or (2) the CTA delivers an advisory agreement for the trading program pursuant to which it will offer commodity interest advice to a client.
RECORDKEEPING
All persons that file a Notice claiming an exemption under the Rules are required to satisfy certain recordkeeping requirements. These include, but are not limited to, making and keeping all books and records prepared in connection with a Manager’s activities as a pool operator for a period of five (5) years from the date of preparation. Furthermore, the books and records must be readily accessible during the first two (2) years of the five-year period and available for inspection upon the request of the CFTC or any other appropriate regulatory agency.
In addition, a fund whose CPO files a Notice claiming an exemption under the Rules must promptly provide every fund participant with a copy of each monthly statement for the fund that the CPO receives from a futures commission merchant and clearly show on such statement, or accompanying supplemental statement, the net profit or loss on all commodity interests closed since the date of the previous statement. Managers must also submit to any special calls from the CFTC to demonstrate eligibility for and compliance with the applicable criteria for exemption under the Rules.
ELIMINATING THE TRADING AND MARKETING RESTRICTIONS FROM RULE 4.5
CFTC Rule 4.5 provides an exclusion from CPO regulation for certain entities that are subject to oversight by other regulatory bodies, such as registered investment companies, pension plans, insurance company separate accounts and bank collective trust funds that trade commodity interests, subject to complying with specified criteria, including trading restrictions, disclosure to investors in the vehicle and filing a notice of eligibility with the CFTC and NFA. In general, the Rule previously limited trading activity to bona fide hedge positions or non-hedge positions for which the aggregate futures margin deposits and options premium do not exceed 5% of the liquidation value of the vehicle’s portfolio. Furthermore, Rule 4.5 had prohibited marketing of the vehicle as a commodity pool or otherwise as a vehicle for trading commodity interests.
Pursuant to the new amendments, Rule 4.5 no longer contains any limitations on the nature or extent of commodity interest trading or to marketing of the entity as a vehicle for trading commodity interests. The Rule continues, however, to require the filing of a notice of eligibility with the NFA. In addition, qualifying entities are required to disclose to investors that its Manager has claimed an exclusion from the definition of a CPO and that, therefore, such Manager is not subject to CPO registration and regulation. As a result, qualifying entities will now be able to participate in the futures markets without having to restrict their trading activities. Anyone who previously claimed relief under Rule 4.5 or the temporary no-action relief is not required to refile its claim.
CURRENTLY REGISTERED CPOs AND CTAs
A CPO currently registered with the CFTC that desires to withdraw from registration and claim an exemption under Rule 4.13 must (1) notify every participant of the pool in writing that it intends to withdraw from registration and claim the exemption, and (2) provide every participant with the right to redeem its interest in the pool prior to the CPO filing a Notice claiming exemption from registration. A CTA currently registered with the CFTC that desires to withdraw from registration and claim an exemption under Rule 4.14 must (1) notify clients in writing that it intends to withdraw from registration and claim the exemption, and (2) provide every client with a right to terminate its advisory agreement prior to the CTA filing a Notice claiming exemption from registration.
Registered CPOs of a fund in which participation is limited to certain classes of highly accredited investors can obtain relief from certain disclosure, reporting and recordkeeping requirements in Part 4 of the CFTC’s Rules (“Part 4 Requirements”). Under Rule 4.7, a Manager who is registered as a CPO is exempt from certain Part 4 Requirements if participation in the pool is limited to QEPs. Rule 4.7 relieves the Manager of the requirement to provide every customer with the mandatory CFTC disclosure document, provided that the offering memorandum is not misleading and prominently displays on its cover page the legend required under the Rule. [9] The Rule also allows Managers to send statements quarterly rather than monthly. In addition, the fund may substitute the required certified annual report for an uncertified annual statement containing, at a minimum, a Statement of Financial Condition and a Statement of Income. To claim the exemption, the Manager must file a simple exemption form with the CFTC. [10]
[1] The definition of a QEP also includes, but is not limited to, persons who (a) own securities (including commodity pool participations) of unaffiliated issuers and other investments with an aggregate market value of at least $2,000,000, (B) have had on deposit with a futures commission merchant (FCM) during the previous six months at least $200,000 in exchange-specified initial margin and option premiums for commodity interest transactions; or (c) own a portfolio comprised of a combination of the funds or property specified in (a) and (b) above in which the sum of the funds or property includible under (a), expressed as a percentage of the minimum amount required thereunder, and the amount of futures margin and option premiums includible under (b), expressed as a percentage of the minimum amount required thereunder, equals at least 100%. An example of an acceptable composite portfolio would consist of $1,000,000 in securities and other property (i.e., 50% of the requirement in (a) above) and $100,000 in exchange specified initial margin and option premiums (i.e., 50% of the requirement in (b) above).
[2] A pre-existing exemption available upon application under Rule 4.7(a) permitted a hedge fund manager to avoid compliance with the CFTC’s requirements regarding disclosure documents, and offered relief from some of the CFTC’s requirements regarding periodic account statements, annual reports to participants and books and records if the hedge fund was open only to QEPs. The Rule 4.7(a) exemption did not, however, exempt Managers from CPO or CTA registration. See, “CURRENTLY REGISTERED CPOs AND CTAs,” below).
[3] A “fund-of-funds” is defined by the CFTC as an investor fund that indirectly trades commodity interests through participation in one or more investee funds that directly trades commodity interests.
[4] The fund of funds, when assessing its own compliance with the five-percent and one-hundred percent limits in clause (iv) above, is permitted to rely on the representations of underlying funds as to the underlying funds’ compliance with the futures trading restrictions in the Rule.
[5] In this case the CPO of the fund-of-funds may aggregate the commodity interest positions across the investee funds to determine compliance with all of the trading restrictions of Rule 4.13(a)(3) set forth in clauses (i) through (iv) above.
[6] The CPO of the fund-of-funds may claim exemption under Rule 4.13(a)(3) because the fund-of-fund’s exposure to the futures markets may be said to be comparable to that of a stand-alone pool that meets the aggregate net notional value test.
[7] The NFA is a non-profit, self-regulatory organization that is charged, together with the CFTC, with the responsibility of regulating the futures markets.
[8] It remains to be seen what will ensue should the SEC withdraw Rule 203(b)(3) as a means to compel all hedge fund managers to register as investment advisers under the Investment Advisers Act.
[9] To qualify for the Rule 4.7 exemption from certain Part 4 Requirements, the Rule requires that the following legend is prominently disclosed on the cover page of the offering memorandum, or, if none is provided, immediately above the signature line on the subscription agreement or other document that the prospective participant must execute to become a participant in the pool:
“PURSUANT TO AN EXEMPTION FROM THE COMMODITY FUTURES TRADING COMMISSION IN CONNECTION WITH POOLS WHOSE PARTICIPANTS ARE LIMITED TO QUALIFIED ELIGIBLE PERSONS, AN OFFERING MEMORANDUM FOR THIS POOL IS NOT REQUIRED TO BE, AND HAS NOT BEEN, FILED WITH THE COMMISSION. THE COMMODITY FUTURES TRADING COMMISSION DOES NOT PASS UPON THE MERITS OF PARTICIPATING IN A POOL OR UPON THE ADEQUACY OR ACCURACY OF AN OFFERING MEMORANDUM. CONSEQUENTLY, THE COMMODITY FUTURES TRADING COMMISSION HAS NOT REVIEWED OR APPROVED THIS OFFERING OR ANY OFFERING MEMORANDUM FOR THIS POOL.”
[10] According to the NFA staff, there is no prescribed form for the Rule 4.7 exemption. A letter to the NFA in the manner prescribed by Rule 4.7(d), attn: Director of Compliance, requesting the exemption will suffice.
For additional information on this topic, you may contact Howard A. Neuman or Carol Spawn Desmond.