On September 17, 2010, the CFTC published a Notice of Petition and Request for Public Comment in respect of a recent petition filed with the CFTC by the National Futures Association The primary purpose of the NFA’s petition was to recommend changes to CFTC Rule 4.5, which is a rule that among other things allows a mutual fund to qualify for an exemption from registration with the CFTC as a commodity pool operator. Comments are due to the CFTC by October 18, 2010
According to the NFA, it is proposing these revisions in order to is to protect retail investors in a mutual fund that is effectively an unregistered commodity fund. Thus, the revised rule would require such a fund to register with the CFTC as a CPO. However, the comments made by the NFA suggest that a much broader universe of mutual funds could be affected, if the rule change is adopted as proposed . Here is what the NFA said about its proposal:
NFA strongly believes that in circumstances in which no qualification requirement exists for fund participants, then NFA and the CFTC should have regulatory oversight of collective investment vehicles that engage in more than a de minimis amount of futures trading.
NFA believes that a registered investment company that is marketed, in part, to unsophisticated retail customers as a commodity pool or otherwise as or in a vehicle for trading in (or otherwise seeking exposure to) the commodity futures or commodity options markets or that engages in more than a de minimis amount of non-hedge futures trading should be subject to the CFTC’s Part 4 regulatory requirements and protections, and the oversight of the CFTC and NFA who have the experience and expertise in regulating managed retail futures products.
As we explain below, all mutual funds that invest in derivatives – futures and swaps- in more than a de minimis amount ought to break out their pens and paper (or fingers and keyboards) and fast – comments are due to the CFTC by October 18, 2010.
CURRENT FORM OF RULE 4.5
In its current form, the rule permits the operator of a 1940 Act fund to qualify for an exclusion from regulation and registration as a “commodity pool operator,” so long as three conditions are met –
- the mutual fund’s registration statement contains disclosure to the effect that the fund’s operator (the registrant trust, for example, on behalf of the portfolio) has claimed the exclusion and is not subject to registration and regulation as a CPO;
- the fund has filed the required notice with the CFTC (via the NFA) to claim the exclusion; and
- the fund submits to any special calls by the CFTC from time to time.
Underlying Rule 4.5 is a policy that the CFTC does not need to regulate mutual funds, since they are already regulated.
THE NFA PROPOSAL – BACK TO THE FUTURE
NFA has proposed amendments to Rule 4.5 in order to re-instate what used to be known as “The Five Percent Test” and the “marketing restriction” – we say “reinstate” and “used to be known” since, if adopted, the proposed amendments will impose the same two operating restrictions on a mutual fund that were in place prior to 2003. At a high level, here are those restrictions:
The Marketing Restriction – The fund will not be, and has not been, marketing participations to the public as or in a commodity pool or otherwise as or in a vehicle for trading in (or otherwise seeking investment exposure to) the commodity futures or commodity options markets.
The 5% Test – The fund will use commodity futures or commodity options contracts solely for bona fide hedging purposes (a term of art under the commodities laws) and, with respect to positions that may be held by the fund only for non-bona fide hedging purposes the aggregate initial margin and premiums required to establish such positions will not exceed five percent of the liquidation value of the qualifying entity’s portfolio, after taking into account unrealized profits and unrealized losses on any such contracts it has entered into.
As alluded to earlier, underlying the proposed amendments to Rule 4.5 is the belief that some mutual funds are, in reality, managed futures funds in disguise. However, if adopted as proposed by the NFA, these amendments cast an extremely wide regulatory net that could snare many other funds (that are not managed futures funds in disguise).
SO, WHAT? YOU ARE SEEING GHOSTS SWAP REPORT!
Really? We think not and here are two reasons why.
First, the regulators have nailed down very few (if any) of the details regarding the regulatory treatment of swaps under Title VII of Dodd-Frank. However, the CPO registration requirements will eventually apply to these (yet to be designated) centrally cleared contracts – and, by extension, Rule 4.5 will be changed to reflect the expanded scope of coverage. So, significantly, at this point in time no one knows what the initial margin or premium requirements will be for a centrally cleared swap. Perhaps a single trade of a particular type of contract will be all that it will take for a mutual fund to fail the 5% test. Maybe not. Until there is some clarity as to the definition of a swap and the establishment of margin requirements, Rule 4.5 should not be amended at all.
Second, even the application of the marketing restriction test is less than clear, due to the evolution of the mutual fund investment and regulatory landscape. The SEC recently told mutual funds to provide investors with more meaningful disclosure about how the funds use derivatives. At what point will the satisfaction of the SEC regulatory requirements constitute marketing participations to the public as a “vehicle for trading in (or otherwise seeking investment exposure to) the commodity futures or commodity options markets”? If proposed as amended – and without further meaningful guidance – a mutual fund that trades securities and also uses derivatives to implement its investment strategies (albeit on more than a de minimis , but not quite a managed futures fund, basis) may be required to register as if it were a managed futures fund in disguise.
In closing, we feel that the NFA’s proposal needs the surgical assistance of the comment letter process to ensure that legitimate mutual fund activities are not unnecessarily subject to overlapping, and possibly inconsistent, regulatory structures.