The Commodity Futures Trading Commission, on February 9, finalized a rule that rescinds an exemption from the registration requirement for investment companies or private funds that want to operate a commodity pool solely for qualified eligible persons.
The new tightened registration system will be effective 60 days after they final rule has been published in the Federal Register. As of this writing, that publication hasn’t happened.
The Commodity Exchange Act authorizes the CFTC to do three pertinent things:
- register commodity pool operators (CPOs) and commodity trading advisors (CTAs);
- impose costs, for example by requiring that every CTA and CPO it has registered “maintain books and records and file such reports in such form and manner” as it may prescribe. Registration, then, creates what is from the point of view of the manager a considerable burden. Finally, for our purposes, there is the authority to;
- create exemptions from registration for situations in which “there is no substantial public interest to be served by the registration.”
Certain exemptions are codified as section 4.13, adopted in August 2003. Part of that, 4.13(a)(4), exempts a CPO from registration if all participants are “qualified eligible persons.” The most newsworthy aspect of the new rule is the abolition of that exemption. There are two reasons for this. The CFTC wants to ensure that it can “adequately oversee the commodities and derivatives markets and assess market risk”; and it wants to prevent incongruence between its own reporting regime and that of other regulatory bodies, notably the Securities and Exchange Commission.
With the enactment of the Dodd-Frank Act (more formally the Wall Street Reform and Consumer Protection Act) in 2010, Congress demanded change. It did not specifically demand changes in the rules relating to CPOs, but it did demand that the SEC change certain rules regarding hedge fund advisors, and the CFTC has decided that a reconsideration of the CPO rules is “consistent with the tenor of the provisions” of that act because the “sources of risk delineated in the Dodd-Frank Act with respect to private funds are also presented by commodity pools.”
According to Timothy Clark, a partner at the multi-national law firm O’Melveny & Myers LLP, there are “hundreds of domestic and foreign hedge fund advisers” that will need to register as a consequence of the new rule.
A Related Development
In a related development, the CFTC is still at work on rules defining “swap” and other swap-related terms. These changes could, like the change to 4.13, have the effect of subjecting to the registration requirement certain entities that have been exempt.
Specifically, under the proposal, entities that meet one of three tests, known collectively as the “major participant tests,” will generally be required to register as a “Major Swap Participant” with the CFTC.
When the swap rulemaking is finalized, it seems likely that in combination with the 4.13 change it will significantly reduce the ability of registered investment companies to fly under the radar in their futures trading – not only as compared to their ability to do so prior to the passage of Dodd-Frank, but even compared to the options that were available to them before August 2003, when 4.13 was adopted.
Consider in this connection the Five Percent Test. Prior to 2003, five percent was a threshold. RICs did not have to register as CPOs so long as their holdings of commodity derivatives did not exceed that threshold percentage of the liquidation value of their portfolios. That threshold disappeared when the CFTC introduced 4.13, precisely as a trade-off with the creation of that exemption for an all-QEP pool. (Another of the exemptions of the 2003 codification continued protect from the mandate investors who engaged only in de minimis futures trading.)
Now, it appears, as part of the new rule, the Five Percent Test has returned, except that it has become more onerous, because the CFTC has decided to include swaps within the activities measured vis-à-vis that threshold – even though it doesn’t know exactly what “swaps” will turn out to be. When it is done defining them, they will count against the threshold.
Commissioner Jill E. Sommers, a former ISDA policy director, voted against this final rule. In her dissenting statement she contends, in effect, that the “tenor” of Dodd-Frank is to be determined as much by what it doesn’t say as by what it does.
Congress, says Sommers, “was aware of the existing exclusions and exemptions for CPOs when it passed Dodd-Frank and did not direct the [CFTC] to narrow their scope or require reporting for systemic risk purposes.”
Further, she writes, “the cost-benefit analysis supporting the rules will [not likely] survive judicial scrutiny if challenged.”