Private funds and the new CFTC paradigm

March 2013 | PROFESSIONAL INSIGHT | FINANCE & INVESTMENT

Financier Worldwide Magazine

A hallmark of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) is its emphasis on transparency and accountability in the financial system. Through the implementation of regulations over the past two-and-a-half years since the adoption of Dodd-Frank, the US Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) have, among other things, expanded registration and reporting requirements to cover many previously exempt advisers to and sponsors of private funds (e.g., hedge, private equity and venture capital funds, as well as other vehicles in which highly sophisticated persons invest), and broadened their oversight responsibilities to include swaps. This included a reduction of the exemptions available to operators of funds – private and registered – that utilise commodity interests and an expansion of the world of commodity interests to include swaps, including those used for bona fide hedging purposes. As a result, many private funds, regardless of their jurisdiction of organisation or place of business, have discovered that they share a common moniker: ‘commodity pool’, making their sponsors/managers ‘commodity pool operators’.

Where operators of private funds were concerned, the CFTC onslaught began in June 2011, with the expansion of ‘commodity interest’ (i.e., the term used to describe the asset class regulated by the CFTC) to include ‘swaps’ as well as commodity futures and options and physical commodities, but really gained momentum in February 2012 with the rescission of the so-called ‘private fund’ exemption (CFTC Rule 4.13(a)(4)) from commodity pool operator (CPO) registration for operators of private funds. Although the CFTC did not adopt the final product definitions, including the definition of ‘swap’, until July 2012, some private fund operators had been aware of SEC and CFTC proposals since May 2011, when the joint proposed rules and interpretive guidance were published. Prior to the rescission of the ‘private fund’ exemption, private funds were permitted to engage in unlimited trading of commodity interests without subjecting their operators to CPO registration. The elimination of the ‘private fund’ exemption, coupled with the CFTC’s position that a fund’s engaging in any commodity interest transaction regardless of purpose or scope would cause it to be a ‘commodity pool’, forced operators of private funds to begin the search for a new exemption or to register as CPOs, in each case by 31 December 2012 (originally, by 12 October 2012 with respect to funds for which the operator had not previously claimed a ‘private fund’ exemption, until the CFTC extended the deadline to 31 December for non-claimants as well as claimants). It also sparked sponsors/managers of many types of vehicles (such as securitisation vehicles, real estate investment trusts, funds operated by non-US persons, family offices, and other specialised investment vehicles) to seek interpretative guidance and no-action relief from the CFTC as to their status.

The other exemption on which private fund operators have occasionally relied is the so-called ‘de minimis’ exemption (CFTC Rule 4.13(a)(3)), which the CFTC decided to retain. It allows operators of funds which engage in limited commodity interest trading to claim an exemption from CPO registration if the fund satisfies one of two tests. The first test provides that if the aggregate margin and premiums required to establish commodity interest positions are no more than 5 percent of the liquidation value of the fund’s portfolio, the fund’s operator can claim the ‘de minimis’ exemption from registration. The second test allows an operator to claim the exemption if the net notional value of commodity interest positions is no more than 100 percent of the liquidation value of the fund’s portfolio. Both of these tests take into account unrealised gains and losses in calculating liquidation value. This exemption is not self-executing and requires the operator to file a notice of exemption with the National Futures Association (NFA), the self-regulatory body for the US futures and swaps industry. A reaffirmation of the notice must be filed with the NFA annually.

Absent an available exemption, an operator of a private fund that engages in commodity interest transactions will need to register as a CPO. Registration involves the filing of forms for both the operator and its associated persons (i.e., persons who solicit orders, customers or customer funds or anyone in such person’s supervisory chain of command) and principals (generally, significant owners, controlling persons and chief compliance officers) as well as other submissions and the satisfaction of certain proficiency tests. It also triggers an obligation on the part of the CPO to comply with certain disclosure, reporting and recordkeeping requirements. Operators of private funds may be able to avail themselves of a ‘registration lite’ regime under CFTC Rule 4.7, which provides relief from certain disclosure, reporting and recordkeeping requirements for registered CPOs of funds whose investors consist only of ‘qualified eligible persons’ (i.e., entities or natural persons that satisfy certain sophistication and, in some cases, portfolio-related criteria). ‘Registration lite’ also requires that the CPO submit a notice of its claim for exemption to the NFA, as well as include all material information in, and prescribed disclaimer language on, any brochure or disclosure statement that it delivers to prospective investors.

As noted previously, certain industry groups have petitioned the CFTC for guidance and relief, and some groups have received no-action and interpretive letters in response to their requests. In a few cases, the applicable funds – equity real estate investment trusts and securitisation vehicles meeting certain criteria – have been excluded from the definition of ‘commodity pool’. The operators of certain other vehicles – business development companies, mortgage real estate investment trusts and single family offices – have received no-action relief, thereby relieving them of the need to register as CPOs while still subjecting them to the antifraud provisions of the Commodity Exchange Act and CFTC oversight. Other guidance has provided some clarity in the fund-of-funds context, allowing an operator of an investor fund to claim time-limited no-action relief if both the operator and the investor fund meet certain conditions.

The regulatory landscape relating to commodity interests for private funds and their operators and advisers (including potential commodity trading advisors as well as investment advisers) is still unfolding. 2013 will likely be a year in which market participants and regulators will deepen their discussions on a host of topics not mentioned here (e.g., extraterritoriality and substituted compliance), as well as focusing on potential relief for operators of other types of vehicles. The paradigm shift initiated by Dodd-Frank is still in its infancy and should prove to be an exercise in regulatory tectonics influenced by the US and global economic, political and legal environment in the years to come.

Alice Yurke and Michael Butowsky are partners at Jones Day. Ms Yurke can be contacted on +1 (212) 326 3623 or by email: ayurke@jonesday.com. Mr Butowsky can be contacted on +1 (212) 326 8375 or by email: mrbutowsky@jonesday.com.

Alice Yurke and Michael Butowsky

Jones Day