Alert February 14, 2012

CFTC Issues Final Rule Amending Registration Exemptions for Registered Investment Companies and Proposes to Harmonize Compliance Obligations for Registered Investment Companies Required to Register as Commodity Pool Operators

The CFTC adopted changes to Part 4 of its regulations involving registration and compliance obligations for commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”).  Among other things, the CFTC amended CFTC Rule 4.5 (the “Rule 4.5 Amendments”) to impose new conditions on the ability of mutual funds and other registered investment companies (collectively, “RICs”) to effect transactions in futures and swaps without the need for CPO registration.  In general, the Rule 4.5 Amendments increase the number of conditions a RIC must meet to claim relief from CPO regulation, in part by reinstating trading and marketing conditions that were part of Rule 4.5 prior to 2003.  The CFTC also issued a proposal designed to facilitate compliance by RICS no longer able to rely on Rule 4.5 with the CFTC’s disclosure, reporting, and recordkeeping requirements (the “Harmonization Proposal”). 

The Rule 4.5 Amendments

The CFTC adopted proposed changes to Rule 4.5 with minor modifications to its February 2011 proposal.  As a general matter, the Rule 4.5 Amendments impose trading threshold and marketing restrictions for RICs claiming exclusion from the CPO definition under Rule 4.5 by largely reinstating certain conditions that were part of Rule 4.5 prior to 2003.  In particular, the Rule 4.5 Amendments restore the condition that aggregate initial margin and premiums related to a RIC’s derivatives positions (other than those entered into for “bona fide hedging” purposes) may not exceed five percent of the liquidation value of the RIC’s portfolio.  In a change from the February 2011 proposal, the Rule 4.5 Amendments introduce an alternative to the 5% initial margin/premiums test.  Under this alternative test, the net notional value of a RIC’s derivatives positions (other than those entered into for “bona fide hedging” purposes) may not exceed 100% of the liquidation value of the RIC’s portfolio. 

In addition to the trading conditions, the Rule 4.5 Amendments reinstate a marketing restriction that was part of the pre-2003 version of Rule 4.5 (the “Marketing Restriction”).  As proposed, the Marketing Restriction would have prohibited the marketing of interests in a RIC “as a vehicle for trading in (or otherwise seeking investment exposure to) the commodity futures, commodity options, or swaps markets.”  In adopting the Rule 4.5 Amendments, the CFTC removed the parenthetical “(or otherwise seeking investment exposure to),” commenting that the clause did not meaningfully add to the restriction.  In the adopting release, the CFTC provided a list of factors it believes are indicative of marketing a RIC as a vehicle for investing in commodity futures, commodity options, or swaps.  In response to public comment, the CFTC also stated that having considered who should register as CPO with respect to a RIC, it had concluded that the investment adviser for a RIC should register in that capacity.

Compliance with amended Rule 4.5 is required by the later of December 31, 2012, or 60 days after the effective date of final rulemaking defining the term “swap.”  Entities required to register due to the amendments to Rule 4.5 will be subject to the CFTC’s recordkeeping, reporting, and disclosure requirements pursuant to part 4 of the CFTC’s regulations within 60 days following the effectiveness of a final rule implementing the Harmonization Proposal, as discussed below.

The Harmonization Proposal

In view of the number of RICs that will no longer be able to rely on Rule 4.5, the CFTC proposed a number of rule amendments intended to harmonize the compliance obligations arising under CFTC rules with those imposed by the SEC.  In this regard, the Harmonization Proposal seeks to minimize the burdens of complying with two compliance regimes by focusing on three areas: (a) delivery of disclosure documents and periodic reports; (b) recordkeeping; and (c) disclosure content.  The following is a brief summary of the CFTC’s proposals in these areas:

Delivery of Disclosure Documents and Periodic Reports. The CFTC’s current regulations require that a CPO deliver to each prospective participant in a pool a disclosure document no later than the time at which the CPO delivers a subscription agreement to such participant.  The CPO may not accept or receive money from a prospective participant unless the CPO first receives from the participant a signed and dated acknowledgment that the participant received the disclosure document.  A registered CPO must also distribute account statements to pool participants, including a statement of operations and a statement of net assets. Such account statements must be distributed monthly for pools with net assets of more than $500,000, and otherwise at least quarterly.

Under the Harmonization Proposal, the CFTC proposes to amend Rule 4.12(c) to permit the CPO of any pool whose units of participation will be offered and sold pursuant to an effective registration statement under the Securities Act of 1933 to claim relief from, among other requirements, the disclosure document delivery and acknowledgement requirements under Rule 4.21 and certain periodic financial reporting obligations under Rule 4.22.  This relief is subject to certain conditions, including that the CPO make the disclosure document readily accessible on its website, and is generally consistent with relief that the CFTC has provided to CPOs of commodity exchange-traded funds (“Commodity ETFs”) with respect to these provisions.  The CFTC is not, however, proposing relief for fund advisers from the content or timing of the monthly account statement requirement, as the CFTC believes that this information is readily available.

Recordkeeping.  Under CFTC Rule 4.23, a CPO must maintain its books and records at its main business office.  The Harmonization Proposal, consistent with the relief granted for Commodity ETFs, would permit the CPO to retain the required books and records with specified third parties. 

Disclosure Content.  The Harmonization Proposal also addresses certain areas in which the CFTC’s and the SEC’s disclosure requirements are in conflict.  These areas include, among others, the following:

  • Performance. Under Rule 4.25(c), CPOs that have less than a three-year operating history, must disclose in a disclosure document the prior performance of pools and accounts other than the commodity pool it is offering.  Under the Harmonization Proposal, the CFTC recognizes that this requirement may conflict with the SEC’s positions regarding the use of past performance and is proposing that the performance of other pools and accounts may be presented in a RIC’s statement of additional information rather than its prospectus.

  • 4.24(a) Cautionary Legend. Under Rule 4.24(a), each disclosure document prepared and distributed by registered CPOs must prominently display the following prescribed cautionary statement on its cover:


    The Harmonization Proposal notes that this cautionary statement differs from the standard disclosure that is required to be included on the front cover of a RIC’s prospectus by the Securities Act of 1933.  Accordingly, the Harmonization Proposal provides flexibility for the RIC to use a statement that combines the SEC and CFTC legends.

  • Break-Even Point and Fees and Expenses Disclosure. Under the Harmonization Proposal, RICs would be required to present in their prospectuses, immediately following the disclosures required by the summary section of SEC Form N-1A, a “break-even point,” which is defined as “the trading profit that a pool must realize in the first year of a participant’s investment to equal all fees and expenses such that such participant will recoup its initial investment, as calculated pursuant to rules promulgated by a registered futures association pursuant to section 17(j) of the Act.”  17 CFR 4.10(j)(1).  The Harmonization Proposal would also require the disclosure of certain fees and expenses in a manner different from Form N-1A. 

  • Updating Amendments.  The Harmonization Proposal would require CPOs and CTAs to file updates of all disclosure documents twelve months from the date of the document, rather than nine months as is currently required. 

Comments on the Harmonization Proposal are due 60 days after its publication in the Federal Register.