On August 8, 2003, the Commodity Futures Trading Commission (the "CFTC") announced a set of final rules designed to amend the rules relating to the exclusions and exemptions from registration for commodity pool operators (each, a "CPO") and commodity trading advisors (each, a "CTA"). Effective as of August 8, 2003, these amendments supersede the temporary no-action relief the CFTC previously issued as set forth in our client advice memorandum dated November 18, 2002, although the CFTC confirmed the continued availability of the temporary no-action relief. The amendments also supersede and supplement CFTC's proposed rules on the same matters as set forth in our client advice memorandum dated March 28, 2003. Furthermore, the CFTC published additional Proposed Rules with respect to bunched orders and performance data and disclosure for CTAs.
A. Exemptions from Registration for CPOs
New Exemptions from Registration for CPOs: Proposed Rules 4.13(a)(3) and (4)
Limited Trading Exemption
New Rule 4.13(a)(3) would exempt a CPO from registration if:
(1) Interests in the pool operated by such CPO are exempt from registration under the Securities Act of 1933, as amended (the "Securities Act"), and such interests are offered and sold without marketing to the public in the United States;
(2) (a) The pool commits no more than five percent (5%) of the liquidation value of the pool's portfolio to establish commodity interest trading positions, whether entered into for bona fide hedging purposes or otherwise; or (b) the aggregate net notional value of the pool's commodity interest trading does not exceed one hundred percent (100%) of the pool's liquidation value;
(3) Each participant in the pool is (a) an "accredited investor"[1]; (b) a trust that is not an accredited investor but that was formed by an accredited investor for the benefit for a family member; (c) a "knowledgeable employee"[2]; or (d) a "qualified eligible person"[3]; and
(4) A CPO claiming relief does not market participations in the pool as or in a vehicle for trading in the commodity futures or commodity options markets.
The term "notional value" is calculated for each such futures position by multiplying the number of contracts by the size of the contract, in contract units (taking into account any multiplier specified in the contract), by the current market price per unit, and for each such option position by multiplying the number of contracts by the size of contract, adjusted by its delta, in contract units (taking into account any multiplier specified in the contract), by the strike price per unit.
The CPO claiming an exemption may net contracts with the same underlying commodity across designated contract markets, registered derivatives transaction execution facilities and foreign boards of trade.
Sophisticated Investor Exemption
New Rule 4.13(a)(4) would also exempt a person from registration as a CPO if interests in the pool for which it seeks to claim relief (1) are exempt from registration under the Securities Act and (2) are offered and sold without marketing in the United States. In addition, the CPO must reasonably believe that (a) natural person participants in such pool are "qualified eligible persons" which are either (i) "qualified purchasers" for purposes of the 1940 Act; (ii) "knowledgeable employees" for purposes of the 1940 Act; or (iii) Non-United States persons (as defined in Rule 4.7); and (b) non-natural person participants in such pool are "qualified eligible persons" or "accredited investors."
Exemptions Applicable to the CPO of a "Fund-of-Funds"
In order to provide guidance on the "limited trading exemption" under Rule 4.13(a)(3) described above in the "fund-of-funds" context, the CFTC adopted new Appendix A to Part 4: "Guidance on the Application of Rule 4.13(a)(3) in the Fund-of-Funds Context." In such Appendix A, the CFTC provided six (6) particular scenarios where the CPO of a fund-of-funds (the "Investor CPO") may claim an exemption from registration without regard to the trading engaged in by the investee fund in which the fund-of-funds invests. It is presumed that the Investor CPO in the following scenarios can comply with all of the other requirements of Rule 4.13(a)(3) and that, where the Investor CPO is relying on its own computations, the fund-of-funds is participating in each investee fund as a passive investor, with limited liability. Persons whose fact situations do not fit any of the scenarios below should contact the CFTC staff to discuss the applicability of the exemption under Rule 4.13(a)(3).
Situation 1
An Investor CPO allocates the fund-of-funds' assets to one or more investee funds, none of which meets the trading limits of Rule 4.13(a)(3) and each of which is operated by a registered CPO. It does not allocate any of the fund-of-funds' assets directly to commodity interest trading. In this situation, the Investor CPO may claim relief under Rule 4.13(a)(3) provided the fund-of-funds itself meets the trading limits of Rule 4.13(a)(3).
Situation 2
An Investor CPO allocates the fund-of-funds' assets to one or more investee funds, each having a CPO who is either: (1) itself claiming exemption from CPO registration under Rule 4.13(a)(3); or (2) a registered CPO that is complying with the trading restrictions of Rule 4.13(a)(3). It does not allocate any of the fund-of-funds' assets directly to commodity interest trading. In this situation, the Investor CPO may rely upon the representations of the investee fund CPOs that they are complying with the trading limits of Rule 4.13(a)(3).
Situation 3
An Investor CPO allocates the fund-of-funds' assets to investee funds, each of which operates under a percentage restriction on the amount of margin or option premiums that may be used to establish its commodity interest positions, e.g., by contractual agreement. It does not allocate any of the assets of the fund-of-funds directly to commodity interest trading. In this situation, the Investor CPO may determine whether the Investor CPO is operating the fund-of-funds in compliance with the "five-percent" under the "limited trading exemption" in Rule 4.13(a)(3) described above by multiplying the percentage restriction applicable to each investee fund by the percentage of the fund-of-funds' allocation of assets to that investee fund.
Situation 4
An Investor CPO allocates the fund-of-funds' assets to one or more investee funds, and it has actual knowledge of the trading limits and commodity interest positions of the investee funds, e.g., where the Investor CPO or one or more affiliates[4] of the Investor CPO operates the investee fund. It does not allocate any of the fund-of-funds' assets directly to commodity interest trading. In this situation, the Investor CPO may aggregate commodity interest positions across investee funds to determine compliance with the trading restrictions of Rule 4.13(a)(3). For this purpose, the aggregate assets of the investee funds would be compared to the aggregate of their commodity interest positions (as to margin or as to net notional value). The Investor CPO should use the results of this computation to determine its compliance with the trading limits of Rule 4.13(a)(3).
Situation 5
An Investor CPO allocates no more than fifty percent (50%) of the fund-of-funds' assets to investee funds that trade commodity interests (without regard to the level of commodity interest trading engaged in by those investee pools). It does not allocate any of the fund-of-funds' assets directly to commodity interest trading. In this situation, the Investor CPO may claim relief under Rule 4.13(a)(3).
Situation 6
An Investor CPO allocates the fund-of-funds' assets to both investee funds and direct trading of commodity interests. In this situation, the Investor CPO must treat the amount of the fund-of-funds' assets committed to such direct trading as a separate pool for purposes of determining compliance with Rule 4.13(a)(3)(i) (the requirement that interests in the pool are exempt from registration under the Securities Act and that there be no marketing to the public in the United States), such that the commodity interest trading of that pool must meet the criteria of each rule independent of the portion of assets of the fund-of-funds allocated to investee funds.
Expanding Existing CPO Exemption under Rule 4.13(a)(2)
Before the amendment, Rule 4.13(a)(2) provided that a person would be exempt from registration as a CPO if: (i) the total gross capital contributions it received for units of participation in all of the pools that it operated or that it intended to operate would not in the aggregate exceed $200,000 and (ii) none of the pools operated by it would have more than fifteen (15) participants at any time, excluding the pool's CPO, CTA, the principals of each and any relative, spouse or relative of the spouse of such person living in the same house as such person.
By amending Rule 4.13(a)(2), the CFTC has expanded the existing exemption above (1) to increase the total of the gross capital contributions criterion from $200,000 to $400,000; and (2) to expand the list of persons who are not counted when calculating the fifteen (15) participants in or capital contributions to such pool. Such expanded list of participants now includes: (a) the pool's CPO, CTA and the principals thereof; (b) a child, sibling or parent of any of the persons listed in (a), above; (c) the spouse of any person listed in (a) or (b), above; and (d) any relative of a person specified in (a), (b) and (c), above, its spouse or relative of its spouse, who has the same principle residence as such person.
Amending the Exclusion from Definition of CPO Under Rule 4.5:
Deleting Trading Criteria for Exclusion and
Marketing Restriction and Adding Disclosure Requirement
Before the amendment, Rule 4.5 excluded from the definition of a CPO registered investment companies, state-regulated insurance companies, banks and pension plans, subject to certain specific limitations on trading known as the "five-percent test." The amendment eliminates the five-percent test. Thus, the qualifying entities under Rule 4.5 would be permitted to trade any amount of futures, whether for hedging or speculative trading.
In addition, Rule 4.5 also prohibited marketing participations to the public as or in a commodity pool or otherwise as or in a trading vehicle for commodity futures or options. The amended Rule 4.5 no longer contains such marketing restriction. However, the amended Rule 4.5 prescribes a new disclosure requirement that a qualifying CPO disclose in writing to each participant, whether existing or prospective, that the qualifying entity is operated by a person who has claimed an exclusion from the definition of CPO. Other restrictions under Rule 4.5 remain the same.
B. Exemptions from Registration for CTAs
Exemptions Related to Incidental Advice Solely Directed to Certain Entities: Rule 4.14(a)(8)
Before the amendment, Rule 4.14(a)(8) provided an exemption from CTA registration for an investment adviser if it were registered as an investment adviser under the Investment Advisers Act of 1940, as amended (the "Investment Advisers Act"), or were exempted from such registration or excluded from the definition of the term "investment adviser" under the Investment Advisers Act, provided that such CTA's commodity interest trading advice were directed solely to pools operated by persons or entities excluded from the definition of a "pool" under Rule 4.5.
The CFTC has now amended Rule 4.14(a)(8) to add new exemptions under this rule to include state-registered, as well as Federally registered, investment advisers, provided that such investment advisers' commodity trading advice is directed solely to, and for the sole use of: (a) "qualifying entities" as that term is defined in Rule 4.5(b) which filed a notice of eligibility; (b) collective investment vehicles excluded from the definition of "pool" under Rule 4.5(a)(4); (c) commodity pools that are organized and operated outside of the United States as long as (1) the CPO of each such pool has not so organized and is not so operating the pool for the purpose of avoiding CPO registration; (2) only Non-United States persons (as defined in Rule 4.7(a)(1)(iv)) are pool participants, except for the pool's operator, advisor and their principals provided that participation in the pool by persons who do not qualify as Non-United States persons or otherwise as qualified eligible persons is limited in the aggregate to less than ten percent (10%) of the beneficial interest of the pool; (3) no person affiliated with the pool conducts marketing activity to solicit anyone other than a Non-United States person; and (4) no person affiliated with the pool conducts any marketing activity from within the United States, its territories or its possessions; and/or (d) commodity pools that meet the requirements of the limited trading exemption and the sophisticated investor exemption described above.
Such investment adviser's commodity interest trading advice must be solely incidental to its business of providing securities or other investment advice to the entities described above and the investment adviser must not be otherwise holding itself out as a CTA.
Counting Legal Organizations as a Single "Person": Rule 4.14(a)(10)
Section 4m(1) of the Commodity Exchange Act, as amended (the "Commodity Exchange Act"), provides an exemption from CTA registration for any person who, during the course of the preceding twelve (12) months, has not furnished commodity interest trading advice to more than fifteen (15) persons and who does not hold himself out generally to the public as a CTA. Before new Rule 4.14(a)(10) was adopted, the CFTC "looked through" any pools to which a CTA relying on the above exemption provides commodity interest trading advise, counting each of the pool's participants towards the fifteen (15) person limit. Under the new Rule, however, the CFTC will count a pool as a single person without "looking through" the pool to count the pool's investors individually.
C. The Effect of the Amendments to Previously Claimed Relief or The Temporary No-Action relief
In November 2002, the CFTC issued temporary no-action relief from CPO and CTA registration pending the determination of a final rule. The CFTC has confirmed the continued availability of the temporary no-action relief. Where a person continues to comply with the commodity interest trading limitations applicable to that previously claimed relief, it does not need to take any other action to take advantage of the exemptions being made available by the amendments described above. The provisions of the no-action relief were set forth in our memorandum dated November 18, 2002 and are restated as below:
No-Action Relief for CPOs: In General
The CFTC will not commence enforcement action against a CPO for failure to register as a CPO where each pool for which the CPO claims registration no-action relief provided that:
(1) Participation in the pool is restricted to "accredited investors", "knowledgeable employees" as that term is defined in Rule 3c-5 under the Investment Company Act of 1940, "non-U.S. persons" as defined in Rule 4.7(a)(1)(iv); and persons described in Rule 4.7(a)(2)(viii)(A); and
(2) One of the following criteria is met at all times:
(a) The aggregate notional initial margin and premiums required to establish such positions, determined at the time the most recent position was established, does not 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 contracts it has entered into; provided that in the case of an option that is in-the-money at the time of purchase, the in-the-money amount as defined in Rule 190.01(x) may be excluded in computing such five percent; or
(b) The aggregate net notional value of such positions, determined at the time the most recent poison was established, does not exceed the liquidation value of the pool's portfolio, after taking into account unrealized profits and unrealized losses on any such contracts in has entered into. For this purpose, the term "notional value" should be calculated for each such futures position by multiplying the size of the contract, in contract units (taking into account any multiplier specified in the contract), by the current market price per unit and for each such option position by multiplying the size of the contract, in contract units (taking into account any multiplier specified in the contract), by the strike price per unit.
No-Action Relief for CTAs
The CFTC will not commence enforcement action against a CTA for failure to register as a CTA, where such CTA meets the following criteria:
(1) It claims relief from CPO registration under the no-action relief described above and its commodity interest trading advice is directed solely to, and for the sole use of the pool or pools that it operates: or
(2) It is registered as an investment adviser under the Investment Advisers Act or with the applicable state securities regulatory agency, or it is exempt from such registration, or it is excluded from the definition of "investment adviser" pursuant to Investment Advisers Act, provided that:
(a) The person's commodity interest trading advice (i) is directed solely to, and for the sole use of, pools operated by CPOs who are eligible to claim relief from CPO registration under the no-action relief; (ii) is solely incidental to its business of providing securities advice to each such pool; (iii) is consistent with the criteria of the CPO registration no-action relief; and
(b) The person is not otherwise holding itself out as a CTA.
D. The Effect of Withdrawal from CPO Registration on Annual Report Requirement
A CPO who has withdrawn from registration in order to claim the temporary no-action relief described above or to claim relief under new Rule 4.13(a)(3) and Rule 4.13(a)(4) nonetheless remains subject to the annual report requirement of Rule 4.22(c).
E. Communications with Clients: Amending Rules 4.21, 4.22 and 4.31
Permitting Communications Prior to Disclosure Document Distribution
Before the amendments, Rule 4.21 and 4.31 prohibited CPOs and CTAs from soliciting prospective pool participants or clients prior to providing a disclosure document. The amended Rules allow CPOs and CTAs to solicit clients before delivering a disclosure document provided that (1) a disclosure document is delivered by such CPO or CTA no later than the time a CPO delivers a subscription agreement for the pool or the CTA delivers an advisory agreement for the trading program for which it is soliciting; and (2) any material distributed in advance of the delivery of the disclosure document is consistent with or amended by the information contained in the disclosure document. In the event such previously distributed information is amended by the disclosure document in any material respect, the prospective participant must be in receipt of the disclosure document at least forty-eight (48) hours prior to its subscription or advisory agreement, as applicable, is accepted by the pool operator.
Removing Duplicative Disclosure Requirements in the Master/Feeder Fund Context
Before the amendments, under Rules 4.21 and 4.22, when a CPO delivered disclosure documents, account statements and annual reports to actual and prospective participants in commodity pools if such actual or prospective participant were a commodity pool (a "Participant Pool"), the CPO was required to also deliver and distribute this information to each participant in each Participant Pool. Under the amended Rules, where the prospective or actual participant is a Participant Pool, the CPO need only deliver a disclosure document, periodic account statements and annual reports to the CPO of the Participant Pool, thus eliminating the duplicative delivery of such information to each of the participants in the Participant Pool.
Distributing Account Statements Electronically; Facsimile Signatures
Additionally, the CFTC has amended Rule 4.22 to permit distribution of annual reports and account statements by electronic means, absent objection from the participant no later than ten (10) days following its receipt of such disclosure. The CFTC has also specifically allowed facsimile signatures on account statements and annual reports, as long as the manual signature from which the facsimile signature is made is kept and the documents filed with the applicable futures association are manually signed.
F. Conforming Signature Requirements under Rules 4.5, 4.7, 4.12, 4.13, 4.14 and 4.22
Finally, the CFTC amended the Rules that list the CPO and CTA signatories who may sign various required documents. These documents must now be manually signed by "a representative duly authorized to bind" an eligible person, CPO or CTA.
All of the final rules described above went into effect as of August 8, 2003. Please note that the relief set forth above is not self-executing. The person claiming the relief must file a notice of eligibility or a notice of claim with the CFTC.
[1] as that term is defined in Rule 501(a) under the Securities Act.
[2] as that term is defined in Rule 3c-5 under the Investment Company Act of 1940, as amended (the "1940 Act").
[3] as that term is defined in Rule 4.7(a)(2).
[4] For this purpose, "affiliate" is defined as a person who controls, is controlled by, or is under common control with, the CPO.