CFTC Issues Final CPO and CTA Rules

By Jeffrey Blumberg, David M. Matteson and Joseph H. Nesler

The CFTC proposed several new rules in two releases over the past year ¡V the first on November 13, 2002 and the second on March 17, 2003. Gardner Carton & Douglas LLP issued two Client Memoranda discussing these proposals in December 2002 and April 2003, respectively. On August 8, 2003, the CFTC released final rules based on those two prior proposals covering a number of issues, including registration and other regulatory relief. This article reviews the final rules as they have been adopted by the CFTC.

Rule 4.5 excludes from the definition of a CPO certain persons that operate various types of regulated investment vehicles, such as registered investment companies, insurance company general accounts and pension plans that are subject to ERISA. However, prior to the amendment, these entities were limited both in the extent to which they could use futures and the type of marketing in which they could engage. Under amended Rule 4.5, these limitations have been removed. The operators of these entities are still required to comply with certain other conditions, such as disclosing to investors in the entities that such operators are excluded from the definition of a CPO and are therefore not subject to registration or regulation as such under the CEA. Moreover, amended Rule 4.5 explicitly states that reliance on the amended rule does not preclude a pool operator from claiming an exemption from CPO registration under amended Rule 4.13 (discussed below) for other types of investment vehicles that it operates.

The amendments to Rule 4.13 liberalize one of the existing exemptions from registration as a CPO and add two new registration exemptions.

First, amended Rule 4.13(a)(2) liberalizes the registration exemption for operators of "small" pools, i.e., pools that have no more than 15 participants per pool and that, in the aggregate, have a limited amount of capital. The categories of persons that do not count against the 15 participant limitation have been expanded to include the children, siblings, parents and spouses of the pool¡¦s operator, CTA and their principals. The aggregate capital limitation applicable to all pools operated by a particular operator under Rule 4.13(a)(2) has been increased from $200,000 to $400,000.

The first of the two new exemptions ¡V Rule 4.13(a)(3) ¡V enables a CPO to avoid registration if, for each pool the CPO operates pursuant to Rule 4.13(a)(3), it complies with all of the following requirements:

• such pool offers and sells its interests in an offering exempt from registration under the Securities Act of 1933 (the "Securities Act");

• such pool does not market its interests to the public in the United States (i.e., the pool must "privately place" its interests to the extent it markets them in the United States);

• such pool does not market itself as a vehicle for trading futures;

• such pool limits sales of its interests to persons who are (or whom the CPO reasonably believes to be):

• "accredited investors" (as that term is defined in Rule 501(a) of Regulation D under the Securities Act);
• trusts that are not accredited investors but that were formed by accredited investors for the benefit of family members;
• "knowledgeable employees" (as that term is defined in Rule 3c-5 under the Investment Company Act of 1940); or
• certain limited types of "qualified eligible persons" under CFTC Rule 4.7(a)(2)(viii)(A);

• such pool meets one of the following tests with respect to its futures positions (including security futures), whether entered into for hedging or speculative purposes, at all times:

• the aggregate initial margin and premiums required to establish such positions, determined at the time the most recent position was established, does not exceed 5% 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% 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);¹ and

• the operator of the pool complies with the requirements described below under "Additional Requirements."

A pool operator that relies on Rule 4.13(a)(3) to avoid CPO registration may also operate pools in reliance on amended Rule 4.5 and new Rule 4.13(a)(4) (discussed below) without subjecting itself to registration (provided, of course, that is complies with the conditions of those rules in relation to such pools).

The second of the two new exemptions ¡V Rule 4.13(a)(4) ¡V enables a CPO to avoid registration if, for each pool the CPO operates pursuant to Rule 4.13(a)(4), it complies with all of the following requirements:

• such pool offers and sells its interests in an offering exempt from registration under the Securities Act;

• such pool does not market its interests to the public in the United States (i.e., the pool must "privately place" its interests to the extent it markets them in the United States);

• such pool limits sales of its interests to persons who are (or whom the CPO reasonably believes to be):

• natural persons who are "qualified eligible persons" within the meaning of CFTC Rule 4.7(a)(2) (qualified eligible persons that are not required to meet the portfolio requirement under CFTC Rule 4.7);² or
• entities that are "qualified eligible persons" within the meaning of CFTC Rule 4.7(a)(2) or (3) or that are "accredited investors" within the meaning of Rule 501(a)(1), (2), (3), (7) or (8) of Regulation D under the Securities Act; and
• the operator of the pool complies with the requirements described below under "Additional Requirements."

A pool operator that relies on Rule 4.13(a)(4) to avoid CPO registration may also operate pools in reliance on amended Rule 4.5 and new Rule 4.13(a)(3) (discussed above) without subjecting itself to registration (provided, of course, that it complies with the conditions of those rules in relation to such pools).

Rule 4.13(a)(4) effectively enables the operator of a pool that relies on Section 3(c)(7) of the Investment Company Act of 1940 (to avoid registration as an investment company) to avoid registration as a CPO.

In order for the operator of a pool to claim the relief provided by amended Rule 4.13(a)(2) and new Rules 4.13(a)(3) and (a)(4), the operator must comply with the following requirements in addition to those summarized above:

A CPO that wishes to rely on Rule 4.13(a)(2), (a)(3) or (a)(4) with respect to a particular pool in order to avoid registration as a CPO must furnish to each prospective pool participant a written statement that:

• discloses that the operator is exempt from registration with the CFTC as a CPO and, therefore, unlike a registered CPO, is not required to deliver a disclosure document or a certified annual report to participants in such pool; and

• describes the basis on which the operator qualifies for exemption from registration.

The operator is required to provide this written statement to a prospective pool participant no later than the time it delivers a subscription agreement for the pool to such prospective participant.

Our recommendation is to include the written statement as part of the offering memorandum for the pool (usually on the cover) or, if the pool will not have an offering memorandum, as part of the subscription agreement itself (generally on the execution page of the agreement).

A CPO that wishes to rely on Rule 4.13(a)(2), (a)(3) or (a)(4) with respect to a particular pool in order to avoid CPO registration must file a notice of exemption with the National Futures Association (the "NFA"). The notice of exemption must include:

• the name, main business address, main business telephone number, main facsimile number and main email address of the CPO and the name of the pool for which it is claiming the exemption;

• the specific rule pursuant to which the CPO is claiming the exemption (i.e., Rule 4.13(a)(2), (a)(3) or (a)(4));

• a representation that the CPO will operate the pool in accordance with the provisions of the applicable rule; and

• the manual signature of a representative duly authorized to bind the operator.

A notice of exemption is not "blanket" in nature (i.e., it does not cover all funds that a CPO operates pursuant to Rule 4.13). Instead, an operator that wishes to avoid registration as a CPO in reliance on Rule 4.13 must file a notice of exemption for each pool that it operates pursuant to the rule.

The notice of exemption with respect to a particular pool must be filed with the NFA prior to the delivery of a subscription agreement for such pool to a prospective investor. For a CPO that is currently registered as such with the CFTC, but that wishes to withdraw its registration and take advantage of the registration relief provided by Rule 4.13, the CPO must first:

• notify all of the current investors in the pool(s) that it operates that it intends to withdraw its CPO registration and claim this relief; and

• provide the investors with an opportunity to withdraw from such pool(s) prior to implementing such change.

A notice of exemption is effective immediately upon filing with the NFA provided that it is materially complete.

Each operator that files a notice of exemption must, within 15 days of the operator becoming aware of any facts or circumstances that make such notice inaccurate or incomplete, file a supplemental notice with the NFA to that effect that includes such amendments as may be necessary to render the notice accurate and complete.

A pool operator that files a notice of exemption under Rule 4.13 with respect to a particular pool with must make and keep all books and records prepared in connection with its activities as the operator of such pool for a period of 5 years from the date of preparation. The operator must keep these books and records "readily accessible" for the first 2 of such 5 years (generally on the operator¡¦s premises), and make all such books and records available for inspection upon the request of any representative of the CFTC or other U.S. regulatory agency with jurisdiction. The operator must also submit to any requests from the CFTC to demonstrate its eligibility to rely on, and its compliance with, the exemption under Rule 4.13.

If a pool for which the operator has filed a notice of exemption under Rule 4.13 distributes an annual report to its participants, that annual report must be presented and computed in accordance with generally accepted accounting principles consistently applied and, if certified by an independent public accountant, must be certified in accordance with the provisions of CFTC Rule 1.16.

A CPO may operate pools under Rule 4.13(a)(3) or (a)(4) even though the CPO is registered with the CFTC as such. While the principal purpose behind Rules 4.13(a)(3) and (a)(4) is to provide an exemption from CPO registration, these rules also greatly reduce the regulation that would otherwise apply to a CPO in connection with operating such pools. Thus, a CPO that is registered as such because, for example, it operates public commodity pools, may nevertheless operate other pools pursuant to Rule 4.13(a)(3) or (a)(4) in order to reduce the regulation that would otherwise apply to it in connection with operating such pools. In this case, however, the CPO must:

• furnish to each prospective participant in any pool that such CPO operates pursuant to Rule 4.13(a)(3) or (a)(4) a written statement that such CPO will operate such pool as if it were exempt from registration as a CPO;

• otherwise comply with the requirements of Rule 4.13(a)(3) or (a)(4), as the case may be.

The application of Rule 4.13(a)(3) to a "fund-of-funds" presents a challenging analysis, so the CFTC included, in Appendix A to its final rule release, several examples of how the rule applies to a fund-of-funds.

The most pertinent of the examples provides that if the operator of a fund-of-funds allocates no more than 50% of the fund- of-fund¡¦s assets to "investee funds" that trade futures (without regard to the extent of such trading) and does not trade any futures directly on behalf of such fund-of-funds, the operator may rely on Rule 4.13(a)(3) in connection with operating such fund-of-funds.

Another example provides that if the operator of a fund-of-funds allocates assets to one or more "investee funds," each of which has a CPO that is either (i) claiming relief under CFTC Rule 4.13(a)(3) or (ii) registered as a CPO but that represents in writing to the operator of the fund-of-funds that the "investee pool" operated by such registered CPO will be managed in accordance with the limitations of Rule 4.13(a)(3), the operator of the fund-of-funds may rely on Rule 4.13(a)(3) in connection with operating such fund-of-funds.

A third example provides that if a fund-of-funds both allocates assets to one or more "investee funds" and directly trades futures interests, the operator of that fund-of-funds must treat each pool of assets (investee funds and direct-traded) as separate pools of assets that must each independently meet the requirements of CFTC Rule 4.13(a)(3).

The examples provided by the CFTC were formulated in response to specific comments letters submitted by the public, so they are not intended to provide an exhaustive overview of the application of the new Rule to a fund-of-funds situation. In our view, based on a reasonable reading of the proposed rule, the comment letters submitted to the CFTC and the final rule, the relief provided by Rule 4.13(a)(3) in the context of a fund-of-funds is potentially much broader than the relief illustrated in the examples. However, the only way to ensure that a specific set of circumstances allows for a claim of exemption is to request clarification directly from the CFTC staff.

The amendments to Rule 4.14 includ several new or modified exemptions from registration as a CTA and adjusted the manner in which a CTA counts its "clients" for purposes of determining whether it qualifies for the exemption from registration as a CTA under Section 4m(1) under the CEA.

Most notably, amended Rule 4.14 exempts from registration a CTA that is registered as an investment advisor with the SEC or any state authority or is exempt from such registration and that provides trading advisory services to any commodity pool operator that qualifies for relief under Rule 4.13(a)(3) or (a)(4), provided that the exempt CTA provides commodity trading advice solely incidental to its business of providing securities or other investment advice to (i) "qualifying entities" (as defined in CFTC Rule 4.5(b)), (ii) collective investment vehicles that are excluded from the definition of the term "commodity pool" under CFTC Rule 4.5(a)(4), (iii) certain commodity pools that are organized and operated outside of the U.S. and its territories or possessions and (iv) pools that qualify for relief under CFTC Rule 4.13(a)(3) and (a)(4).

Just as a CPO claiming relief under Rule 4.13 must file a notice with the NFA, a CTA that wishes to rely on Rule 4.14 must file a notice of exemption with the NFA that includes:

• the name, main business address, main business telephone number, main facsimile number and main email address of the CTA;

• the specific rule pursuant to which the CTA is claiming exemption (i.e., Rule 4.14(a)(8)(i) or (a)(8)(ii)) „hƒna representation that it will provide futures trading advice in accordance with the provisions of the applicable section; and

• the manual signature of a representative duly authorized to bind the CTA.

The notice of exemption must be filed with the NFA prior to the delivery of an advisory agreement to a prospective client.

For a CTA that is currently registered as such with the CFTC, but that wishes to withdraw its registration and take advantage of the registration relief provided by Rule 4.14, the CTA must first:

• notify all of its current clients that it intends to withdraw its registration and claim such relief; and

• provide its clients with an opportunity to terminate their advisory agreements before implementing such change.

The claim of exemption is effective immediately upon filing provided that it is materially complete.

Each exempt CTA that files a notice of exemption must, within 15 days of the CTA becoming aware of facts or circumstances that make the notice inaccurate or incomplete, file a supplemental notice with the NFA to that effect that includes such amendments as may be necessary to render the notice accurate and complete.

The same requirements that apply to an exempt CPO with respect to (i) making and keeping books and records in connection with its futures-related activities, (ii) the time periods for which such books and records must be kept and (iii) submitting to requests from the CFTC to demonstrate its eligibility to rely on, and its compliance with, the exemption it is claiming also apply to an exempt CTA.

The other significant change with respect to CTAs is related to the de minimis exemption provided in Section 4m(1) of the CEA that provides that a CTA that provides commodity trading advice to no more than 15 persons during any 12 month period is not subject to the registration requirements under the CEA. Until the release of the amended Rule 4.14, a CTA counted each investor in a pool to which it provided commodity trading advice as a client for purposes of determining its eligibility for the de minimis exemption under Section 4m(1). Under the amended rule, the CTA generally can count a pooled investment vehicle as a single investor for purposes of making this determination.

Neither a CPO nor a CTA that claimed the relief available under the Temporary No-Action Relief provided by the proposed rule releases nor a CPO that claimed relief under the old Rule 4.5 must re-file its claim to maintain such relief, provided that it continues to comply with the applicable provisions of the amended rule. However, CPOs that took advantage of the Temporary No-Action will want to revise the disclosure language that they included in their disclosure documents to remove the references to the Temporary No-Action Relief and include the information that is now required for the notice of exemption under Rules 4.13 (as discussed above).

Any CPO that withdraws its registration as such and claims the relief available under Rule 4.13(a)(3) or (a)(4) remains subject to the annual report requirement under Rule 4.22(c) for the year in which the withdrawal is effective. The rationale for this requirement is that for some portion of that year, the CPO was subject to the annual report requirement, and the investors in the pool invested or remained invested in the pool under the expectation that they would receive an annual report.

The CFTC has also revised these three rules to allow CPOs and CTAs to communicate with prospective investors or clients prior to the delivery of the relevant disclosure document to such prospective investor or client. The amended rules require a disclosure document to be provided to the prospective investor or client no later than the time a CPO delivers a subscription agreement to a prospective investor or a CTA delivers an advisory agreement to a prospective client. Any information provided to the prospective investor or client prior to the delivery of the relevant disclosure document must be consistent with that disclosure document or, if it is not consistent, the disclosure document must be provided to such person no less than 48 hours prior to the acceptance of the subscription agreement or advisory agreement by the CPO or the CTA, respectively.

The CFTC issued an interpretation in July 1997 regarding electronic delivery of disclosure documents that included, among other things, a requirement that a CPO or CTA that included certain information on its website provide a summary risk disclosure and a link to the CPO¡¦s or CTA¡¦s full disclosure document along with such information. This interpretation was based on the requirement that a CPO or CTA deliver a disclosure document to prospective investors and clients at the time a solicitation was made. Under the amended rules, this requirement no longer exists, so the provisions of the amended Rules 4.21 and 4.31 supercede the provisions of the 1997 interpretation.

The CFTC has also established the conditions by which a CPO may deliver the required periodic investor reports, including periodic account statements and annual reports, required under the CEA by electronic means (e.g., email). In order to provide these materials electronically, the CPO must notify the pool¡¦s investors of its intent to distribute reports electronically and provide the investors with no less than 10 business days to object to such distribution medium. In practice, for a pool that is accepting new investors, if the pool¡¦s disclosure document clearly states that all reports will be provided electronically, a new investor is effectively consenting to receiving such reports electronically. Thus, the 10 business day notice requirement is more relevant to pools that want to start sending electronic reports to their existing investors.

CTAs and CPOs are generally required to provide "performance capsules" that summarize the performance history of any accounts or pools such CTA or CPO operates. The performance capsules are required to include information on both open and closed accounts. The CFTC wanted to allow flexibility in format for presenting the performance information of clients who have opened and closed their accounts during the period for which performance is required to be disclosed. The final rules allow disclosure both the number of accounts and the range of ROR for all accounts closed with a positive ROR and for all accounts closed with a negative ROR. CTAs may use alternative methods such as standard deviation.

CTAs and CPOs must also include information in their performance capsules regarding "drawdowns" (i.e., client losses). In the past, the staff required the drawdown calculation to be based on the worst performing account. Under the amended rules, the CFTC will accept drawdown information on a composite basis for all client accounts that participated in a particular trading program or pool. In the event there are material differences among the accounts, those differences must be disclosed.

Rates of return of CTAs are calculated by dividing the composite net performance by the dollar amount of funds under management. Additions and withdrawals of capital affect the denominator and, accordingly, can distort the ROR. The CFTC¡¦s final rules allow two methods of accounting for additions and withdrawals in calculating ROR. The two methods are daily compounding and time-weighting of additions and withdrawals. On a prospective basis, the CFTC also eliminated the "only accounts traded" (or "OAT") method, as an acceptable method of accounting for additions and withdrawals. Appendix B to Part 4 includes examples to assist CTAs in applying each alternative method of calculation.

Since 1987, the CFTC has advised CTAs as to the appropriate method to calculate ROR for partially-funded accounts. The staff position has changed over the years. The CFTC retreated from its specific proposals issued in March of this year which would have included the notional portion of the allocation in the calculation and adopted the "core principle" approach. The core principle for presenting past performance results requires that the results be presented in a manner that is balanced and not in violation of the Commodity Exchange Act or CFTC regulations. In its adopting Release, the CFTC stated that Advisory 93-13 (the Fully-Funded Sub-set Method) will remain in effect and NFA will adopt specific rules for its CTA members regarding performance presentation of partially-funded accounts. Historically, the NFA has endorsed including notional fund in ROR calculations. The NFA has also approached notional funds as a disclosure and compliance issue, rather than as an accounting issue.