Real Estate Fund Managers and the CFTC

Many real estate fund managers, used to the lack of regulatory oversight, are wrestling with the implications of Dodd-Frank. One of the biggest sources of hand-wringing is whether to register as an investment adviser given the removal of the 15 clients exemption from the Investment Advisers Act. Another agency is potentially making regulatory changes leading to a registration requirement.

The Commodity Futures Trading Commission has proposed removing some exemptions from the requirement to register as Commodity Pool Operator or a Commodity Trading Advisor. I have never paid much attention to these requirement. That is because interest rate swaps and foreign exchange hedges generally fell outside the definition of a commodity.

However, Section 712(d)(1) of the Dodd-Frank Act empowers the CFTC and SEC to define swaps and could re-classifies “swaps” as “commodities”. That brings these formerly unregulated contracts under the regulatory regimes of the CFTC and the SEC. Under the comprehensive framework for regulating swaps and security-based swaps established in Title VII of Dodd-Frank, the CFTC is given regulatory authority over swaps and the SEC is given regulatory authority over security-based swaps. They can fight over mixed swaps.

The concern I have is that a real estate fund is likely to have “swaps” in place to reduce interest rate risk. If they are operating overseas, they may have hedges in place to reduce foreign exchange risk. Since those are likely to fall under the new definition of swap, and there is no end-user exemption, the real estate fund and its manager could now also fall under the regulatory regime of  the CFTC.

CFTC Rule 4.13(a)(3) currently exempts a fund from registration as a Commodity Pool Operator if:

• the fund’s interests are exempt from registration under the Securities Act of 1933 (’33 Act);
• the investors in the fund are only Qualified Eligible Persons, accredited investors or knowledgeable employees;
• the pool’s aggregate initial margin and premiums attributable to futures and options on futures do not exceed 5 percent of the liquidation value of the pool’s portfolio;
• the fund is not marketed at a vehicle for trading in commodity futures or commodity options markets.

Rule 4.13(a)(4) currently exempts you from registration as a Commodity Pool Operator if the interests in the fund are exempt from registration under the ‘33 Act and the operator reasonably believes all participants are Qualified Eligible Persons or accredited investors.

The CFTC  is proposing to eliminate these exemptions because it is concerned that they are big loopholes from exemption. I think an unintended consequence could be dragging real estate funds and real estate operators into the regulatory framework.

I have to admit that I’ve just started reading the swap rules and the CFTC framework so I don’t understand how it all fits together. Frankly, the provision in Dodd-Frank and the proposed rules are a mess and full of inconsistencies, making this situation even harder to figure out and likely creating some unintended consequences.

Sources:

• CFTC Rule 4.13
• CFTC Rulemaking implementing Rule 4.13 in 2003 (.pdf)
• Joint SEC CFTC Proposed Rule Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping (.pdf)
• Do I need to register as a CPO or CTA with the CFTC/NFA? from the Investment Fund Law Blog
• CFTC Proposes to Repeal or Restrict Exemptions From Commodity Pool Operator and Commodity Trading Advisor Regulation from Skadden, Arps, Slate, Meagher & Flom LLP