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CFTC Memo to Investment Companies – You’re Commodity Pool Operators, Too

February 17, 2012

On February 9th, the CFTC published new final rules amending Part 4 of the Commission’s regulations involving registration and compliance obligations for commodity pool operators (“CPOs”) and commodity trading advisers (“CTAs”). Although not required by the Dodd-Frank Act, the agency used the purpose behind the Act – increased transparency, reduction of risk, market integrity – as justification for its amendments.

Photo by lucathegalga. Some rights reserved.

The amendments rescind the exemption from registration provided in Section 4.13(a)(4) for qualified purchaser funds; rescind relief from the certification requirement for annual reports provided to operators of certain pools offered only to qualified eligible persons under Section 4.7(b)(3); and require the annual filing of notices claiming exemptive relief under several sections of the CFTC’s regulations. Finally, the adopted amendments include new risk disclosure requirements for CPOs and CTAs regarding swap transactions.

Section 4.5. Perhaps the most sweeping aspects of the CFTC’s new rules, however, do not really involve CPOs or CTAs; they involve SEC-registered investment companies. Section 4.5 will require investment companies to register with the CFTC if the investment company’s derivatives trading exceeds five percent of the liquidation value of its portfolio. Included within that five percent threshold are all swaps, futures, and risk management hedging activities. The CFTC does provide for an alternative threshold based on a net notional test. Under the net notional test, entities may claim a registration exemption if the aggregate net notional value of the entity’s commodity interest positions does not exceed 100 percent of the liquidation value of the commodity pool’s portfolio. 

Marketing Restrictions. Section 4.5 also prohibits investment companies from marketing themselves as a vehicle for trading in commodity futures, commodity options, or swaps markets. In response to commenters’ requests, the final rule provides guidance on the factors the agency will consider as indicative of prohibited marketing. Those factors are: (1) the fund’s name; (2) whether the fund’s primary investment objective is tied to a commodity index; (3) whether the fund makes use of a controlled foreign corporation for its derivatives trading; (4) 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; (5) 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; (6) whether the futures/options/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 (7) whether the fund is explicitly offering a managed futures strategy.

Controlled Foreign Corporations. The CFTC believes that registered investment companies invest up to 25 percent of their assets in controlled foreign corporations (“CFCs”), which then engage in actively managed derivatives strategies. The CFTC does not oppose the continued use of CFCs by registered investment companies, but wants them to be subject to regulation. Therefore, CFCs will be required to have their CPOs register with the CFTC unless they may claim exemption or exclusion on their own merits.

Compliance. Compliance with the amendments to Section 4.5 for purposes of registration only will occur on the later of either December 31, 2012, or within 60-days following the adoption of final rules defining the term “swap,” and establishing margin requirements for such instruments. Entities required to register due to the amendments to Section 4.5 shall be subject to the CFTC’s recordkeeping, reporting, and disclosure requirements set forth in part 4 within 60 days following the effectiveness of a final rule implementing the CFTC’s proposed harmonization effort.

Harmonization. Recognizing that requiring investment companies to register as CPOs may lead to duplicative or inconsistent regulatory requirements, the CFTC separately proposed rules meant to harmonize a registered investment company’s SEC and CFTC compliance obligations. It published for comment exemptive provisions that would be available to advisers of registered investment companies who are required to register as CPOs. The exemptive provisions relate to (1) the delivery of disclosure documents and periodic reports; (2) the cycle for updating disclosure documents; (3) the timing of financial reporting to participants; and (4) the SEC-permitted use of a summary prospectus of open-ended registered investment companies. Comments should be submitted within 60 days after publication in the Federal Register, which is expected during the week of February 20.

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