The extension of the Commodity Futures Trading Commission’s jurisdiction to cover swaps will affect any fund with U.S. investors and its manager/adviser if it enters into any swap transactions (such as interest rate or FX hedging transactions) even if all of the fund, its manager and the swap transactions are outside the United States.
CFTC Regulation of Swaps
Title VII (the “Derivatives Act”) of the Dodd-Frank Wall Street Reform and Consumer Protection Act provides a comprehensive framework for regulating OTC derivatives. Significantly, the Derivatives Act for the first time empowers the CFTC to regulate swaps.
Under the Commodity Exchange Act (“CEA”), as amended by the Derivatives Act, swaps are now considered “commodity interests” and need to be considered when determining whether a fund is a “commodity pool” and whether the operator or adviser to the fund is a Commodity Pool Operator (“CPO”) or Commodity Trading Adviser (“CTA”). Following are some of the key terms, as amended:
- A “Commodity Pool” is “any investment trust, syndicate, or similar form of enterprise operated for the purpose of trading in commodity interests, including any… commodity for future delivery, security futures product, or swap. . .”. Therefore a fund of any type (unit trust, partnership, investment trust, etc.) that has entered into any swap transaction, even for the purpose of hedging, is likely to be a commodity pool.
- A “Commodity Pool Operator” is any person “engaged in a business that is of the nature of a commodity pool… and who, in connection therewith, solicits, accepts or receives from others, funds, securities or property... for the purpose of trading in commodity interests, including any… commodity for future delivery, security futures product or swap. . .” The manager or general partner of a fund is therefore likely to be a CPO.
- A “Commodity Trading Advisor” is any person “who, for compensation or profit, engages in the business of advising others... as to the value of or advisability of trading in… any contract of sale of a commodity for future delivery, security futures product, or swap . . .” The fund’s delegate investment manager or adviser is therefore likely to be a CTA.
Funds-of-funds that invest in other funds that trade commodity interests may also be Commodity Pools even if the investing fund does not hold any commodity interests directly.
Although these definitions refer to “operated for the purpose of trading in commodity interests”, the CFTC staff takes the position that entering into a single commodity interest transaction may be sufficient to cause a fund to be a Commodity Pool. Based on this interpretation, a fund that enters into a single swap or other commodity interest transaction needs to consider its status as a Commodity Pool for purposes of the CEA and the operator and adviser of such fund should consider the need to register as a CPO and CTA, respectively, or establish an available exemption.
Definition of Swap
The definition of “swap” in the CEA is very broad and includes, for example, interest rate swaps, cross-currency rate swaps, currency swaps, commodity swaps, interest rate caps and floors, among other types of transactions.
Currently, foreign exchange forwards and foreign exchange swaps are “swaps” and are counted as commodity interests for purposes of determining if a fund is a commodity pool. The Secretary of the Treasury has the authority to exclude these types of transactions from the definition of swap for certain purposes under the CEA and CFTC regulations, and while an exclusion has been proposed, it has not been adopted.
Exemptions and Exclusions
De minimis Exemption for CPOs (CFTC Regulation 4.13(a)(3)
The De Minimis Exemption exempts from registration CPOs with respect to Commodity Pools that satisfy the following requirements:
- Registration Restrictions: The Commodity Pool is exempt from registration under the Securities Act of 1933 and offered without marketing to the public in the United States. Funds that have been marketed in the United States on a private placement basis should meet this criteria.
- Investor Restrictions: The CPO has a reasonable belief that US investors are “accredited investors”, “knowledgeable employees” or “qualified eligible persons”.
- Marketing Restrictions: The Commodity Pool is not marketed as a commodity vehicle.
- Trading Restrictions: One of two tests must be met:
- the aggregate initial margin, premiums, and required minimum security deposit for retail forex transactions required to establish commodity interest positions (including securities futures positions), determined at the time the most recent position was established, will not exceed 5 percent of the liquidation value of the pool's portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into; or
- the aggregate net notional value of such positions, determined at the time the most recent position was established, does not exceed 100 percent of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into.
- Disclosure to Prospective Investors. It is disclosed to each prospective investor in the Commodity Pool that the CPO is exempt from registration under the De Minimis Exemption and therefore, unlike a registered CPO, is not required to deliver a disclosure document or a certified annual report to investors.
- Notice. CPOs that rely on this exemption must file an initial notice of claim with the National Futures Association (the “NFA”), which must be renewed on an annual basis
CPOs that rely on the De Minimis Exemption will have ongoing compliance obligations. They will need to re-file a notice of claim for the De Minimis Exemption with the NFA within 60 days after each calendar year end, amend the notice if it becomes inaccurate, maintain CPO books and records for five years and submit to “special calls” by the CFTC or NFA to verify that the requirements of the exemption are met. CPOs that rely on the De Minimis Exemption may face other considerations, such as whether the Volcker Rule will treat the fund as a private fund that raises issues for companies subject to the rule (as the current draft suggests), whether the end user exemption that would allow a fund not to clear swap transactions would apply (which it may not) and whether the fund could take full advantage of the regulations expected under the JOBS Act (and it currently appears the fund may not be able to do so).
There are three relevant exemptions for CTAs:
CFTC Regulation 4.14(a)(8)(i). This exemption is available to CTAs whose commodity interest trading advice is directed solely to CPOs that have claimed the De Minimis Exemption. A CTA relying on this exemption must (i) provide commodity interest trading advice solely incidental to its business of providing investment advice and not otherwise hold itself out as a CTA, and (ii) file an initial notice of claim with the NFA which must be renewed on an annual basis.
CTAs that rely on this exemption will have some ongoing compliance requirements. They will need to re-file a notice of claim for the exemption with the NFA within 60 days of the calendar year end, amend the notice if it becomes inaccurate, maintain CTA books and records for five years and submit to “special calls” by the CFTC or NFA to verify that the requirements of the exemption are met.
“15 or Fewer” Exemption (CEA §4m(1)/ CFTC Regulation 4.14(a)(10)). CTAs who do not hold themselves out to the public as CTAs and who have not provided commodity interest trading advice to more than 15 clients during the prior 12 months are exempt from registering as CTAs. For purposes of this exemption, a fund is typically counted as one client, and non-U.S. CTAs need count only their U.S. clients toward the limit. A notice filing is not required in order to claim this exemption. While this exemption, more properly described as an exception, is of value to CTAs, there is no equivalent exclusion for CPOs.
“Not Primarily Engaged” Exception (CEA §4m(3)). An SEC registered investment adviser whose business does not consist primarily of acting as a CTA and that does not act as a CTA to any Commodity Pool that is engaged primarily in trading in commodity interests is exempt from registering as a CTA. CEA § 4m(3)(B) provides that a CTA or Commodity Pool is “primarily engaged” in the business of being a CTA or Commodity Pool if it is or holds itself out to the public as being engaged primarily, or proposes to engage primarily, in the business of advising on commodity interests or investing, reinvesting, owning, holding or trading in commodity interests, respectively. A notice filing is not required in order to claim this exception.
CPOs and CTAs that are exempt or excepted from registering with the CFTC based on any of the above regulatory and statutory provisions are nonetheless subject to the CFTC’s anti-fraud and advertising rules.
Is the fund a “Commodity Pool”?
In light of the changes described above, general partners, managers and investment advisers to funds that previously were not subject to CFTC jurisdiction, including private equity funds, private real estate funds and venture capital funds, will now need to consider if the funds they manage are Commodity Pools. If their funds are Commodity Pools, they essentially have three options: (i) qualify for one of the remaining CPO/CTA exemptions, as applicable; (ii) manage their funds such that the funds no longer use swaps or other commodity interests subject to the CFTC’s jurisdiction; or (iii) register the managing entity with the CFTC as a CPO and the advising entity as a CTA.
Although private equity funds, private real estate funds and venture capital funds do not typically trade in swaps or commodity interests for speculative purposes, they do sometimes utilize interest rate, foreign exchange, and currency swaps for hedging purposes. If, as the CFTC Staff has indicated, entering into a single swap transaction is sufficient to cause a fund to be a Commodity Pool, then, for example, a private equity fund that enters into a single interest rate swap is a Commodity Pool under the new definitions. Furthermore, if a fund itself does not enter into commodity interest transactions but a portfolio company or other special purpose vehicle held by the fund does enter into commodity interest transactions then the fund may nonetheless be deemed to be a Commodity Pool to the extent it is indirectly invested in commodity interests. This analysis would depend on the facts and circumstances of the structure and whether or not the portfolio company or other special purpose vehicle that holds the commodity interests is itself a Commodity Pool.
The CFTC has recently issued some interpretive guidance with regard to the definition of “commodity pool.” In particular, in response to a 4 September 2012 letter from the National Association of Real Estate Investment Trusts (the “NAREIT Request Letter”), the CFTC’s Division of Swap Dealer and Intermediary Oversight issued interpretative guidance on 11 October 2012 stating that real estate investment trusts (“REITs”) that satisfy the following criteria are not “commodity pools” as that term is defined in Section 1a(10) of the Commodity Exchange Act and CFTC Regulation 4.10(d):
- The REIT primarily derives its income from the ownership and management of real estate and uses derivatives only to hedge interest rate or currency risk;
- The REIT complies with the requirements of a REIT election under the Internal Revenue Code (including the 75 percent test and the 95 percent test); and
- The REIT identified itself as an equity REIT in Item G of its last U.S. income tax return on Form 1120-REIT and continues to qualify as such.
This interpretive guidance is limited to REITs that meet the criteria specified, although the letter includes language that may provide an opportunity for requests for further guidance with respect to other types of real estate funds.
European managers and advisers may, therefore, be able to benefit from one or more of the above CFTC exemptions. Where the CTA benefits from the “15 or Fewer” exemption or the “Not Primarily Engaged” exception, no filing is required, but firms should be aware that annual filings are necessary where a CTA is relying on the CFTC Regulation 4.14(a)(8)(i) exemption or a CPO is relying on the De Minimis Exemption, among other requirements.