The CFTC adopted rule amendments (the “Harmonization Rule”) designed to harmonize certain CFTC compliance obligations that apply to commodity pool operators (“CPOs”) of investment companies registered under the Investment Company Act of 1940 (the “1940 Act”) (“RICs”) with the compliance obligations imposed on RICs by the SEC. Through the Harmonization Rule, the CFTC has, in effect, adopted a “substituted compliance” regime for CPOs of RICs that is based largely upon adherence to the SEC’s statutory and regulatory compliance regime. As stated in the adopting release for the Harmonization Rule (the “Adopting Release”), the CFTC “will accept compliance by [CPOs of RICs] with the disclosure, reporting and recordkeeping regime administered by the SEC as substituted compliance with part 4 of [CFTC] regulations.” The Harmonization Rule should be substantially less burdensome for CPOs of RICs than the CFTC’s original harmonization proposal. In addition to the Harmonization Rule, the CFTC adopted rule changes that apply to all CPOs; these changes affect the updating and acknowledgement requirements for disclosure documents and CPO recordkeeping obligations.
As described in the February 14, 2012 Financial Services Alert (the “February 2012 Alert”), the CFTC previously adopted changes to part 4 of its regulations involving registration and compliance obligations for CPOs and commodity trading advisors (“CTAs”). Among other things, the CFTC amended Rule 4.5 (the “Rule 4.5 Amendments”) to impose additional conditions on the ability of RICs to effect transactions in futures and swaps without the need for CPO registration by a RIC’s investment adviser. In general, the Rule 4.5 Amendments increased the number of conditions a RIC must meet for its adviser to be able to claim relief from CPO registration, in part by reinstating trading and marketing conditions that were part of Rule 4.5 prior to 2003. At the time, the CFTC also issued a proposal (the “Harmonization Proposal”) designed to facilitate compliance with the CFTC’s disclosure, reporting, and recordkeeping requirements by CPOs of RICs no longer able to rely on Rule 4.5, as described in the February 2012 Alert. While CPOs of RICs no longer able to claim the exemption from CPO registration were required to register as of the end of 2012, the CFTC suspended most of the obligations that would have applied to CPOs of RICs under part 4 of the CFTC’s regulations, pending final action on the Harmonization Proposal.
the Harmonization Rule – CPOs of RICs
The Harmonization Rule provides an exemption from most of the compliance obligations imposed on CPOs of RICs under the Commodity Exchange Act (“CEA”) if the following broad conditions are met:
- the CPO (and as applicable, the RIC it advises) complies with the disclosure requirements of the 1940 Act, the Securities Act of 1933 (the “1933 Act”), the Securities Act of 1934, the rules and regulations promulgated thereunder and any guidance issued by the SEC and its staff (collectively, the “SEC RIC Rules”);
- the CPO (and as applicable, the RIC it advises) complies with conditions, as described in CFTC Rule 4.12(c), keyed to certain CFTC rules from which the Harmonization Rule provides an exemption, which are discussed in greater detail below; and
- the CPO files a notice with the National Futures Association (“NFA”) that the CPO is relying on the relief provided by the Harmonization Rule.
The Adopting Release notes that any failure to comply with the SEC RIC Rules will constitute a violation of the CPO’s obligations under part 4 of the CFTC’s regulations and subject the CPO to enforcement action by the CFTC.
Filing and Updating Requirements
The CPO of a RIC relying on the Harmonization Rule is exempt from the requirement in CFTC Rule 4.26(d) that a CPO submit its disclosure documents to the NFA prior to distributing them to participants; however, those documents must be made available to the NFA during the course of an examination. The CPO of a RIC relying on the Harmonization Rule is similarly exempt from the disclosure document updating requirements of CFTC Rule 4.26(a)(2) and, accordingly, will be permitted to update fund documents in accordance with the SEC RIC Rules. CFTC Rule 4.26(c) requires a CPO to correct material inaccuracies in a disclosure document within twenty-one days of the date upon which the CPO first becomes aware of the defect. The CPO of a RIC relying on the Harmonization Rule is exempt from this requirement and need only comply with the disclosure updating requirements under the SEC RIC Rules.
Delivery of Disclosure Documents
The CPO of a RIC relying on the Harmonization Rule is exempt from CFTC Rule 4.21, which requires a CPO to deliver a disclosure document to each prospective participant, and obtain from that prospective participant a signed acknowledgment of receipt of the disclosure document before accepting or receiving funds from that participant, if the CPO complies with the disclosure delivery requirements under the SEC RIC Rules, which includes the use of a summary prospectus. The CPO of a closed‑end RIC relying on the Harmonization Rule is not required to maintain current disclosure documents if the RIC is not soliciting participants.
CFTC Rules 4.24(n) and 4.25 require a significant amount of disclosure regarding a commodity pool’s past performance, including, in the case of a commodity pool with less than a three-year operating history, disclosure of the past performance of each other pool and account that the CPO has operated. A CPO relying on the Harmonization Rule is exempt from the performance disclosure requirements under Rules 4.24(n) and 4.25 with respect to a RIC it advises, provided that in the case of a RIC that has less than a three-year operating history, it discloses the performance of all accounts and pools managed by the CPO that have investment objectives, policies and strategies that are substantially similar to those of the RIC.
On the same day that the CFTC issued the Adopting Release, the SEC’s Division of Investment Management issued IM Guidance Update No. 2013-05 (the “IM Guidance Update”) to provide guidance on disclosure and compliance matters relating to the use of derivatives by RICs. (See here for more on the IM Guidance Update). In relevant part, the IM Guidance Update reaffirms the previously expressed views of the SEC staff to the effect that a RIC “may include in its prospectus information concerning the performance of private accounts and other funds managed by the [RIC’s] adviser that have substantially similar investment objectives, policies and strategies to the [RIC], provided that the information is not presented in a misleading manner and does not obscure or impede understanding of information that is required to be included in the [RIC’s] prospectus (including the [RIC’s] own performance information).”
Legends (Cautionary Statements) and Risk Disclosures
Cautionary Statement. CFTC Rule 4.24(a) requires a specific “cautionary statement” to appear prominently on the cover page of the CPO’s disclosure document. The Harmonization Rule permits the CPO of a RIC to satisfy the CFTC cautionary statement requirements through appropriate modification of the prospectus legend required by Rule 481 under the 1933 Act, as specified in the Adopting Release. Similarly, the IM Guidance Update provides that the SEC staff will not object if a RIC whose adviser registers as a CPO incorporates required CFTC cautionary statement disclosures into the Rule 481 prospectus legend.
Risk Disclosure. CFTC Rule 4.24(b) requires a disclosure statement regarding standard risks associated with the use of commodity interests. A CPO relying on the Harmonization Rule is exempt from including the standard risk disclosure statement of Rule 4.24(b) if the RIC it advises complies with the disclosure requirements under the federal securities laws, including the SEC RIC Rules.
CFTC Rule 4.24(g) requires the inclusion of a commodity pool’s principal risk factors in its disclosure document. The CPO of a RIC relying on the Harmonization Rule satisfies this obligation by complying with the disclosure requirements of Forms N-1A and N-2, and related guidance from the SEC staff, including the IM Guidance Update and the 2010 letter from the Division of Investment Management regarding disclosure about derivatives (described in the August 17, 2010 Financial Services Alert). The Adopting Release further notes that CPOs of RICs must comply with any applicable SEC guidance that may be issued in the future regarding these disclosure requirements, “which the [CFTC] will evaluate for consistency with its own regulatory interests.”
Break-Even Point and Fee Disclosure
CFTC Rule 4.24(d)(5) requires CPOs to include in the forepart of the disclosure document the break-even point per unit of initial investment. The CPO of a RIC relying on the Harmonization Rule is exempt from the disclosure requirements of Rule 4.24(d)(5) if the RIC is in compliance with the SEC RIC Rules.
Other Conditions for Reliance on the Substituted Compliance Regime
In addition to the conditions and requirements described above, a CPO and, as applicable, any RIC it advises, seeking to rely on the Harmonization Rule must:
- cause the current net asset value per share of a RIC to be available to all participants;
- cause shareholder reports required under the SEC RIC Rules to be accessible on a website maintained by the CPO or its designee or otherwise be made available to participants and disclose the internet address of the website, if applicable; and
- file with the NFA the RIC’s financial statements required under the SEC reporting regime.
Controlled Foreign Corporations
The Adopting Release reaffirmed the CFTC’s view that a controlled foreign corporation (“CFC”) used by a RIC may fall within the definition of a “commodity pool” depending on the CFC’s activities. The Adopting Release states that if a RIC provides disclosure regarding the activities of a CFC in accordance with SEC RIC Rules, the CFC will not be required to prepare a separate disclosure document that complies with part 4 of the CFTC regulations. Further, if the CFC’s financial statements are consolidated into those of its parent RIC that are filed by the RIC with the NFA, the CFTC will not require the CFC to file separate financial statements.
Form CPO-PQR and CTA-PR Filing Requirements
When the CFTC adopted the Rule 4.5 Amendments, it also established reporting requirements for CPOs and CTAs on new Forms CPO-PQR and CTA-PR, respectively, but suspended compliance with these requirements for CPOs and CTAs of RICs pending final action on the Harmonization Proposal. The Adopting Release provides that in conjunction with the adoption of the Harmonization Rule, CPOs and CTAs of RICs will generally become subject to applicable Form CPO-PQR and CTA-PR filing requirements beginning October 21, 2013. The NFA has similar reporting requirements on NFA Form PQR (and soon, NFA Form PR). The NFA’s website summarizes the requirements for the CFTC and NFA reporting forms.
Rule Changes for All CPOs
In conjunction with the Harmonization Rule, the CFTC also adopted the following changes to its regulations under part 4 that will apply to all CPOs regardless of the type of commodity pool:
- CPOs may use third-party service providers to maintain their books and records subject to certain conditions.
- A CPO is no longer required to secure a signed acknowledgment of receipt of the disclosure document for a pool before the CPO may accept or receive funds from that participant.
- CPOs may update their disclosure documents on a 12-month basis instead of a 9-month basis.
The amendments to CFTC rules applicable to all CPOs relating to recordkeeping and extending the updating cycle for disclosure documents will become effective on September 23, 2013. The rescission of the signed acknowledgement requirement became effective on August 22, 2013.
The issue of compliance dates applicable to CPOs of RICs with respect to the rule changes affecting all CPOs and with respect to the various elements of the Harmonization Rule is complicated by the fact that the adoption of the Harmonization Rule triggers the conditional compliance date regime established when the CFTC adopted the Rule 4.5 Amendments. The effect of this regime has been to delay the commencement of the compliance obligations for CPOs of RICs to which the Harmonization Rule relates until 60 days after the Harmonization Rule is effective. The Investment Company Institute (ICI) has requested formal written clarification from the CFTC staff regarding the compliance dates for the elements of the Harmonization Rule and for the rule changes affecting all CPOs as they apply to CPOs of RICs. Accordingly, the following summary of compliance dates for CPOs of RICs seeking to rely on the Harmonization Rule and the amendments applicable to all CPOs is subject to revision based on the CFTC staff’s response to the ICI’s request:
A RIC CPO seeking to rely on the exemption in CFTC Rule 4.12(c)(3) will be required to comply with most of the conditions described herein, including filing with the NFA a notice that the CPO intends to use the “substituted compliance” regime, by October 21, 2013. However, a RIC CPO will not need to meet the conditions in CFTC Rule 4.12(c)(3)(i) (primarily presentation of comparable fund performance information for RICs with less than a three year operating history) until the RIC’s first filing on or after November 22, 2013, as follows:
- Open-End RIC - in its initial registration statement or in the next post-effective amendment that is an annual update to an existing registration statement.
- Closed-End RIC - in its initial registration statement or when it is next required to update its registration statement.
A RIC CPO must begin complying with the recordkeeping requirements of CFTC Rule 4.23 (as revised) no later than November 22, 2013.
A RIC CPO must file with the NFA the notice required with respect to the use of a third-party recordkeeper no later than November 22, 2013.
With respect to Form CPO-PQR and CTA-PR filings, as described above, the Adopting Release provides that in conjunction with the adoption of the Harmonization Rule, CPOs and CTAs of RICs will generally become subject to applicable Form CPO-PQR and CTA-PR filing requirements beginning October 21, 2013. This means that existing CPOs and CTAs of RICs will be required to make their initial filings with respect to the reporting period ending December 31, 2013.