Category: CFTC

CFTC Allows General Solicitation for Private Funds

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In early 2013, the Commodity Futures Trading Commission decided to grab for more regulatory oversight and revoked some long-standing exemptions. The CFTC also got handed the regulatory oversight of non-securities derivatives. As a result, private funds with interest rate hedges had to figure out if they had to register with the CFTC as a commodity pool operator. One of the limitations with registration was a ban on advertising.

As required by the Jumpstart Our Business Startups Act in July 2013 the Securities and Exchange Commission amended Rule 506 to permit “general solicitation” and “general advertising” for private placements as long as certain other conditions are met.

Private funds could advertise under the SEC rules, but could not under the CFTC rules.

Last week, the Commodity Futures Trading Commission issued an exemptive letter that would allow private funds treated as commodity pools to use the JOBS Act general solicitation provisions.

Private fund sponsors who relied on a CPO registration exemption under CFTC Regulation 4.13(a)(3) or exemptive relief from certain registered CPO obligations under CFTC Regulation 4.7(b) were prohibited from engaging in general advertising or general solicitation under Rule 506(c). CFTC Regulation 4.13(a)(3) requires that interests in an applicable pool must be “offered and sold without marketing to the public in the United States”. I heard some arguments that the limitation only prevented advertsing as a commodity pool. Few felt comfortable with that position.

Exemptive Letter No. 14-116 provides exemptive relief from certain provisions in Regulations 4.7(b) and 4.13(a)(3) and permits CPOs relying on these Regulations to engage in general advertising and general solicitation under Rule 506(c). For some reason the CFTC decided to not make the exemption self-executing.

You need to make a filing. In order to rely on the exemptive relief in Letter 14-116, you must make a written claim for the exemption by filing with the CFTC.

This is good news for funds that want to use 506(c) or at least avoid the public marketing footfault in fundraising. The only question is why did it take the CFTC over a year to fix its mistake.

Sources:

  • Exemptive Letter No. 14-116 (.pdf) Exemptive Relief from Provisions in Regulations 4.7 (b) and 4.13 (a)(3) Consistent with JOBS Act Amendments to Regulation D and Rule 144

Do U.S. Regulators Listen to the Public?

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Regulators get piles of comment letters on proposed rules. But do the comments have an affect? Three math and finance professors tried analyzed the text of comments and regulations to find and answer.

Andrei A. Kirilenko, Shawn Mankad, and George Michailidis created a regulatory analytical tool called RegRank. The three researchers pointed RegRank at the CFTC and the 104 proposed rules the commission issued between January 2010 and September 2013. Those proposed rules resulted in 60,000 comment letters and 67 final rules.

The researchers used RegRank to rate a particular proposed rule, final rule and comments as pro-regulation or anti-regulation.  Then they use the tool to characterize how the CFTC rules evolved.

The data indicates that the regulators adjust the rules based on comments.

reg rank

There is a general pattern of a proposed rule becoming more in line with the calculated sentiment of the comment letters when it becomes a final rule.

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Mortgage REITs Get Relief from the CFTC

The CFTC continues the journey out of the hole it dug itself. In February the CFTC stated that one swap contract would be enough to trigger the registration requirement. This runs with the CFTC long standing narrow interpretation of the commodity pool definition. The CFTC retreated from this position with respect to REITs in October. The CFTC has also retreated from this position for Mortgage REITs.

Mortgage REITs are a bit trickier because the underlying assets are real estate loans instead of real estate. There is likely to be more financial engineering with derivatives to mange the risks in the portfolio.

The CFTC lays out four tests for relief:

  1. No more than 5% of assets are for initial margin and premiums
  2. Net income from derivatives is less than 5% of income
  3. Interests in the mortgage REIT are not marketed as a commodity pool
  4. The company has made or will make the IRS filing as a mortgage REIT

Unlike the REIT relief, the mortgage REIT relief is not self-executing. The Mortgage REIT needs to send an email no-action relief claim.

In footnote 19, in bold type, the CFTC continues to backpedal:

The Division notes that we remain open to discussions with mREITs to consider the facts and circumstances of their mREIT structures with a view to determining whether or not they might not be properly considered a commodity pool.

The CFTC also release an interpretative letter offering no action relief for securitization vehicles. Word is that there may be a few more letters providing relief in the works.

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CFTC Relief for Funds of Funds

The CFTC has given funds of funds six more months to determine whether they needs to register as a commodity pool operator. Dodd-Frank has made interest rate and some foreign exchange derivatives “commodities” and made them subject to oversight by the CFTC. There is a December 31, 2012 deadline approaching. However, the CFTC rescinded guidance to help funds of funds determine how and when to look through their investments to determine if the fund of fund is a commodity pool.

However, the Managed Fund Association and Investment Adviser Association are concerned that their members do not yet have enough access to the underlying information from their investment funds to make the determination. And the CFTC has not issued new guidance to replace the guidance they rescinded.

This relief is not self operative. There are detailed instructions in the no-action letter stating what steps the fund manager needs to take.

I still have a problem that the is applies to a commodity pool operator, that is contingent on there actually being a commodity pool. The CFTC has not helped with that definition which still relies on the fund being organized for the purpose of trading in commodities.

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What is a Commodity Pool?

The CFTC stretched when it said that a fund entering into even a single swap used purely for hedging purposes — will hold “commodity interests” and accordingly could be viewed as commodity pools by the CFTC. The CFTC has construed the concept of commodity pool broadly and has consistently maintained that there is no minimum trading threshold for qualification as a CPO.

The big complication is that interest rate derivatives are now considered commodity interests and subject to CFTC oversight. Up until a few weeks ago, foreign exchange derivatives were also considered a commodity interest. On November 16, 2012, the US Department of the Treasury issued a final determination  that foreign exchange swaps and certain foreign exchange forwards are not commodity interests.

In looking closer at the statutory definition of “commodity pool” it seems that single swap should not turn a private fund into a commodity pool.

Title 7 of the US Code Section 1(a)

(10) Commodity pool

(A) In general
The term ‘‘commodity pool’’ means any investment trust, syndicate, or similar form of enterprise operated for the purpose of trading in commodity interests, including any—
(i) commodity for future delivery, security futures product, or swap;
(ii) agreement, contract, or transaction described in section 2(c)(2)(C)(i) of this title or section 2(c)(2)(D)(i) of this title;
(iii) commodity option authorized under section 6c of this title; or
(iv) leverage transaction authorized under section 23 of this title.

From the statutory definition, the fund needs to operated for the purpose of trading in commodity interests.

One argument is that the fund is an end user and therefore not organized for the “purpose of trading in commodity interests.” Under the new end user exception to the swap clearing requirement, the key test is whether the entity is “using the swap to hedge or mitigate commercial risk.”

What is a swap used to hedge or mitigate commercial risk?

(c) Hedging or mitigating commercial risk.

For purposes of section 2(h)(7)(A)(ii) of the Act and paragraph (b)(1)(iii)(B) of this section, a swap is used to hedge or mitigate commercial risk if:

(1) Such swap:

(i) Is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, where the risks arise from:

(A) The potential change in the value of assets that a person owns, produces, manufactures, processes, or merchandises or reasonably anticipates owning, producing, manufacturing, processing, or merchandising in the ordinary course of business of the enterprise;

(B) The potential change in the value of liabilities that a person has incurred or reasonably anticipates incurring in the ordinary course of business of the enterprise;

(C) The potential change in the value of services that a person provides, purchases, or reasonably anticipates providing or purchasing in the ordinary course of business of the enterprise;

(D) The potential change in the value of assets, services, inputs, products, or commodities that a person owns, produces, manufactures, processes, merchandises, leases, or sells, or reasonably anticipates owning, producing, manufacturing, processing, merchandising, leasing, or selling in the ordinary course of business of the enterprise;

(E) Any potential change in value related to any of the foregoing arising from interest, currency, or foreign exchange rate movements associated with such assets, liabilities, services, inputs, products, or commodities; or

(F) Any fluctuation in interest, currency, or foreign exchange rate exposures arising from a person’s current or anticipated assets or liabilities; or

(ii) Qualifies as bona fide hedging for purposes of an exemption from position limits under the Act; or

(iii) Qualifies for hedging treatment under:

(A) Financial Accounting Standards Board Accounting Standards Codification Topic 815, Derivatives and Hedging (formerly known as Statement No. 133); or

(B) Governmental Accounting Standards Board Statement Accounting and Financial Reporting for Derivative Instruments; and

(2) Such swap is:

(i) Not used for a purpose that is in the nature of speculation, investing, or trading; and

(ii) Not used to hedge or mitigate the risk of another swap or security-based swap position, unless that other position itself is used to hedge or mitigate commercial risk as defined by this rule or Sec. 240.3a67-4 of this title.

I think most private equity funds and real estate private equity funds would be using interest rate derivatives to hedge or mitigate commercial risk.

The tough part of this argument is that a “financial entity” is not an end user.

2(h)(7)(C)(i)‘‘financial entity’’ means—

(I) a swap dealer;
(II) a security-based swap dealer;
(III) a major swap participant;
(IV) a major security-based swap participant;
(V) a commodity pool;
(VI) a private fund as defined in section 80b–2(a) of title 15;
(VII) an employee benefit plan as defined in paragraphs (3) and (32) of section 1002 of title 29;
(VIII) a person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 1843(k) of title 12.

In case you have forgotten about the definition of private fund under Dodd-Frank:

The term “private fund” means an issuer that would be an investment company, as defined in section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a–3), but for section 3(c)(1) or 3(c)(7) of that Act.

The end user exemption excludes private funds. That seems bad and is going to kick all of the newly registered private equity and real estate private equity funds out of the end-user exemption.

On top of that, there is a de minimis exemption from registration under the terms of Rule 4.13(a)(3). Under these requirements, either:

  • Initial margin and premiums for commodity interest transactions must be less than 5% of the liquidation value of the fund; or
  • Aggregate net notional value of commodity interest transactions must be less than 100% of the liquidation value of the fund.

That still leaves me stuck with trying to figure out when an entity becomes a commodity pool. The regulations provide no further guidance. One case that addresses the definition is Lopez v. Dean Witter Reynolds 805 F.2d 880 1986. Unfortunately for my purposes it focuses on whether separate accounts are aggregated enough to be a pool.

In CFTC v. Heritage Capital Advisory Services, Ltd. (Comm. FUT. L. REP. (CCH) 21,627, 26,377 (N.D. Ill. 1982).) the ruled that a fund investing in Treasuries and hedging the risk was a commodity pool. The defendants had solicited and pooled public funds with the stated intention of investing approximately 97% of the proceeds in United States Treasury bills, and using the remainder to hedge the account by trading futures contracts on Treasury bills. The ruling concluded that “[t]he risk to the funds of the defendants’ investors far exceeded the 3% discount which was supposedly to be committed to the futures markets” because of the possibility of a rapid decrease in the applicable market or of the pool being required to take delivery of costly Treasury bills pursuant to a future contract.

That does not provide much help for private equity funds and real estate private equity funds.

 

 

Will the CFTC Extend the Registration Deadline?

Private equity funds with interest rate swaps or foreign exchange hedges have been wringing their hands over registration with the Commodities Futures Trading Commission. Dodd-Frank has brought those derivative instruments into the oversight of the CFTC. Shortly, they will be considered commodities. That means funds that previously did not consider themselves to be trading in commodities could be subject to CFTC registration.

The CFTC decided to provide no guidance as what would make a fund a commodity pool. In a regulatory release earlier this year, the CFTC said that even a single interest rate or foreign exchange trade could make a fund a commodity pool.

The downside to registration is that it will likely prohibit the fund from being able to take advantage of the “end-user” exemption for commodity trading. A commodity pool would be considered a financial entity and would be subject to the new clearing requirements.

The other troubling part of the CFTC regulatory framework is that it is at odds with the JOBS Act. The likely exemption for most private funds would require the fund to not engage in general solicitation or advertising. The JOBS Act started the process for lifting that ban for Regulation D offerings, the usual method for investments in private funds.

On top of that fund of funds are scrambling because of the look-through requirement. In deleting an old exemption the CFTC also delete the guidance used by fund of funds.

Let’s add some of the confused reasoning of the CFTC when it released the NAREIT guidance letter stating that REITs are not commodity pools. Rumor has it that there are some additional guidance letters in the works.

All of this confusion still exists with just a month left for compliance. The Investment Adviser Association and Managed Funds Association have thrown their hands up in the air and asked the CFTC to extend the compliance deadline.

A CFTC Exemption for Private Equity Funds

The CFTC is going to dramatically expand its realm through the one-two punch of gaining regulatory control over non-securities derivatives and the removal of a widely used exemption. (With the release of REITs from the definition of “commodity pool” perhaps the CFTC is loosening its grip.) Fortunately, there is another exemption that most private equity funds will be able to utilize. But it requires some math.

CFTC Regulation 4.13(a)(3) contains a “De Minimis Exemption.” To take advantage of the exemption a fund must satisfy these requirements:

  1.  The Funds is exempt from registration under the Securities Act of 1933 and offered without marketing to the public in the U.S.
  2.  The CPO has a reasonable belief that investors are “accredited investors”, “knowledgeable employees” or “qualified eligible persons”.
  3. The fund discloses 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.
  4. File an initial notice of claim with the National Futures Association, and renew on an annual basis.
  5. One of two trading tests must be met:
  • 5% cost: 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
  • 100% value: 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.

What’s not clear to me is how portfolio companies and subsidiaries fit into the tests. I assume you would treat a wholly-owned subsidiary as you would treat fund -level activity. At some point the fund’s ownership in an entity should remove it from being part of the fund level calculation. I just have not dived deep enough into the CFTC world to figure out where that threshold is.

For private equity funds and real estate funds, the 100% test may be close depending on the type of leverage used and the risk mitigation used. However, the 5% cost should be easy. Interest rate swaps and foreign exchange hedge are usually very cheap, less than 5% of the nominal value of the hedge.

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REITs and the CFTC

Dodd-Frank’s Title VII is likely to sweep a bunch of private equity fund operators under the CFTC’s registration requirement. The CFTC stated that a single interest rate swap or foreign exchange hedge could drag the fund manager into the definition of “Commodity Pool Operator” (7 USC §1a(10) and have to register with the CFTC. The National Association of Real Estate Investment Trusts was also concerned the equity REITs that use interest rate hedges could be considered a commodity pool.

The CFTC released an interpretative letter releasing REITs from the grasps of the CFTC. The CFTC agrees with the NAREIT position that REITs are operating companies and are therefore not commodity pools.

But will this interpretative letter help real estate private equity funds? Most real estate private equity funds have a REIT somewhere in their structure, so the letter offers some benefit.

The CFTC notes that equity REITs are, in part, operating companies because they engage in substantial management and operational function. (Check for real estate funds.)

Equity REITs use derivatives is limited to supporting its primary focus on real estate ownership and operation. (Check for real estate funds.)

The CFTC list three criteria for this relief:

  • The REIT primarily derives its income from the ownership and management of real estate and uses derivatives for the limited purpose of “mitigat[ing] their exposure to changes in interest rates or fluctuations in currency”;
  • The REIT is operated so as to comply with all of the requirements of a REIT election under the Internal Revenue Code, including 26 U.S.C. §856(c)(2) (the 75 percent test) and 26 U.S.C. §856(c)(3) (the 95 percent test); and
  • The REIT has 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, or, if the REIT has not yet filed its first tax filing with the Internal Revenue Service, the REIT has stated its intention to do so to its participants and effectuates its stated intention.

I’m not yet sure if this gets a real estate fund all the way out of CFTC registration. I think there will be more to come.

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First the SEC, Now the CFTC

The Dodd-Frank Wall Street Reform and Consumer Protection Act is getting ready to land its second regulatory punch to private equity funds. The first was the registration requirement with the Securities and Exchange Commission. The second is the upcoming registration requirement with the Commodities Futures Trading Commission.

Two recent developments pull fund managers into the CFTC’s world. The first is the inclusion of interest rate and foreign exchange swap transactions into the regulatory oversight of the CFTC. That’s part of the Dodd-Frank regulation of derivatives. The second is the repeal of a popular exemption from registration. That exemption was available for funds that were limited to investors that were accredited investors and qualified eligible persons. That exemption will cease to be available after December 31, 2012.

Title VII (the “Derivatives Act”) of Dodd-Frank creates a new framework for regulating derivatives. Securities derivatives get SEC oversight, but non-securities derivatives get CFTC oversight.

Under the Commodity Exchange Act, as amended by the Derivatives Act, swaps are now considered “commodity interests” and need to be considered when determining whether an entity is a “commodity pool” and whether the operator or adviser to the entity is a Commodity Pool Operator or Commodity Trading Advisor.

  • 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. . .””
  • A “Commodity Pool Operator” (a “CPO”) 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. . .”
  • A “Commodity Trading Advisor” (a “CTA”) 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 . . .””

I don’t think most private equity funds would consider themselves to be “trading” in commodity interests. However, the CFTC release indicates that entering into a single commodity interest transaction would be sufficient to cause a fund to be a Commodity Pool. So, a fund that enters into a single interest rate hedge could be treated as a Commodity Pool and the adviser of the fund would have to register as a CPO or CTA, or establish an available exemption.

I would guess that the CFTC will have a few thousand new registrants by the end of the year. Fortunately, there is another exemption that should allow many funds to avoid the full regulatory oversight of the CFTC. More on that later.

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Are You a CPO?

The first question is what is a CPO and why should I care? The Commodities and Futures Trading Commission decided to tighten the exemptions from registration potentially pulling some hedge funds and private equity funds that previously ignored the CFTC. Davis Polk held a webinar on this topic. Some private fund managers may get the CPO label and have to deal with the CFTC regulatory regime.

CPO is the CFTC acronym for “Commodity Pool Operator”, which refers to any person engaged in the business of soliciting investors for an investment trust operated for the purpose of trading in commodity interests.

  • Commodity interests include futures (including agricultural, metal and financial futures), commodity options and, upon the issuance of final rules under Dodd-Frank, swaps.
  • Swaps include a wide variety of transactions, including interest rate swaps, many types of currency swaps, energy and metal swaps, agricultural swaps, commodity swaps, swaps on broad-based indices, and swaps on government securities.

The CFTC has long expressed the view that transacting in any amount of futures contracts (either directly or indirectly) would cause a fund sponsor to be deemed a commodity pool operator. There is no de minimis exception in the definition. So the CFTC position results in the conclusion that fund sponsors who have interest rate swaps or foreign exchange swaps will likely be deemed to be commodity pool operators and will need to evaluate whether an exemption is available. Even a funds of funds may also be deemed to be commodity pools depending on the investment activities of underlying funds.

There used to be a broad exemption. CFTC Rule 4.13(a)(4) provides a blanket exemption from CPO registration for sophisticated investor funds (i.e., those offered to Qualified Purchasers). The CFTC has decided to rescind this exemption.

A private fund sponsor will be required to register unless each of its funds satisfies the de minimis trading limitations under the terms of Rule 4.13(a)(3). Under these requirements, either:

  • Initial margin and premiums for commodity interest transactions must be less than 5% of the liquidation value of the fund; or
  • Aggregate net notional value of commodity interest transactions must be less than 100% of the liquidation value of the fund.

In addition to those de minimis trading requirement, Rule 4.13(a)(3) is available so long as:

  • the fund is offered privately to certain types of investors; and
  • the fund is not marketed as a vehicle for trading in the commodity futures or commodity options markets.

Investors in a Rule 4.13(a)(3) vehicle may include, among others:

  • any accredited investors under Reg D; and
  • knowledgeable employees as defined under Rule 3c-5 under the 1940 Act and certain other employees.

Most private equity and real estate private equity fund should be able to meet these hurdles and can focus on the 5% margin test and the 100% net notional exposure test.

5% margin test: The aggregate initial margin and premiums for commodity interest transactions (and minimum security deposits for retail forex transactions) must be less than 5% of liquidation value of the fund (including unrealized profits and losses to date).

100% net notional exposure test: The aggregate net notional value of commodity interest positions must not exceed 100% of the liquidation value of the fund.

  • Notional value is defined by asset class.
  • Futures contracts are valued by multiplying the number of contracts by the size of the contract.
  • Futures options are based on the strike price per unit and adjusted by the option’s delta.
  • Futures contracts with the same underlying commodity may be netted across markets.
  • Notional value of swaps cleared by the same DCO may be netted, “where appropriate”.

The 5% margin test or 100% net notional exposure tests are required to be met at each time that a commodity position is established.

The CFTC has requested comments during the 60-day period beginning on Friday, February 11, 2011.  If the proposed rule is adopted, the CFTC will issue a final rule that will specify when hedge fund and other private fund managers relying on CFTC Rules 4.13(a)(3) and 4.13(a)(4) will need to revise or cease their commodity interest trading or register as CPOs (and, if applicable, CTAs) and become members of the NFA.

The text of the proposed rule can be found here: http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2011-2437a.pdf