Tag: CFTC

What does the CFTC have to do with private equity?

PEI PFC Forum 2013

These are my notes from the Private Fund Compliance Forum 2013. They are live from the Forum so please forgive my typos.

Robert E. Phay, Jr., Associate General Counsel & Chief Compliance Officer, Commonfund

The common sense answer should be “nothing”. But that does not seem to be the case. The CFTC seems to be trying to broaden its grasp.

Dodd-Frank pulled interest rate derivatives and foreign exchange derivatives into the definition of a “commodity”.

Interest rate swaps and foreign exchange hedges are now commodities so trading in those could trigger CFTC registration. There is an exemption under Rule 4.13(a)(3) called the de minimis rule. You have to have less 5% of the liquidation value of the fund in commodities or the notional value is less than 100% of the fund value.

Regulation 4.13(a)(3) requires that the trading limits must be complied with “at all times.” However, the provisions of Regulation 4.13(a)(3) qualify that requirement, stating that such limits are determined “at the time the most recent position was established.” When these requirements are read together, staff believes that it is clear that the regulation only requires that a CPO be in compliance with the trading thresholds at the time a position is established. A CPO would not otherwise be required to reconfigure its portfolio to comply with such limits.

If you have more commodities in excess of the de minimis amounts then you need to worry about other registration and the requirements of the Commodities Exchange Act.

Fund of funds have special rules under 4.13(a)(3) with a look through to the underlying funds.

This all ties back to the jurisdiction over swaps and adherence to the ISDA protocol.

There is a Department of the Treasury exemption for Foreign exchange swaps and forwards. You still need to adhere to the ISDA protocol for these. You just don’t need to comply with the central clearing requirement. It’s not an exemption from the business conduct rule.

The Commodity Exchange Act definition of “commodity pool”:

(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.

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.

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.

Sources:

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

The Slow Rulemaking on Swaps and Derivatives

One of the strange splits in US financial regulation is that many swap and derivatives are regulated by the Commodities Futures Trading Commission instead of the Securities and Exchange Commission. I think of the CFTC, I think of Trading Places and with the SEC I think of Wall Street.

The Commodity Futures Trading Commission has delayed its rollout of regulations under the Dodd-Frank Wall Street Reform and Protection Act has been pushed back until at least early 2012. This delay is the second time the CFTC has put the brakes on its new rules that will govern the over-the-counter derivatives market. In my view, taking longer to get the rules right is better than pushing through bad rules just to meet some arbitrary deadline. The question will be whether the CFTC will succeed in creating rules that will make the derivatives market one that is more transparent and easier to oversee for lines of trouble.

As for trouble, take a look at Greek bonds as an example. The Credit Default Swaps cost a record $5.8 million upfront and $100,000 annually to insure $10 million of Greece’s debt for five years using credit-default swaps. That means the market is saying it’s about a 58% chance that Greece will default in the next five years. But how extensive is that exposure in the US? How many people are on the hook for payouts if Greece defaults?

If your firm uses derivatives or swaps for dealing with debt risks or foreign exchange risks, you should pay attention to the CFTC rulemaking. They are likely to change the process and the cost of dealing with these risks.

Gary Gensler, Chairman of the CFTC, says that “until the CFTC completes its rule-writing process and implements and enforces these new rules, the public remains unprotected. That’s why the CFTC is working so hard to ensure that swaps-market reforms promote more open and transparent markets, lower costs for companies and their customers, and protect taxpayers.”

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:

Feds Release Usable Model Consumer Privacy Notice

There was much cheering when federal regulators finally released their Final Model Privacy Notice Form back in November.

That was quickly followed by a gnashing of teeth when it turns out the regulators did not understand the concept of a form or how to use Adobe Acrobat. They merely created a static document that you would have to spend hours trying to recreate.

They finally released version of the model privacy notice that is a fillable form using adobe acrobat.

To obtain a legal “safe harbor” and so satisfy the Gramm-Leach-Bliley Act’s disclosure requirements, institutions must follow the instructions in the model form regulation when using the Online Form Builder.

Sources:

New Anti-Money Laundering Guidance

Money Laundering is bad and financial institutions need to have internal controls policies, procedures and processes to identify higher-risk accounts and monitor the activity. At the core of an anti-money laundering program is that an institution must know its customers and the risks presented by its customers.

The program becomes more difficult when the customer is a corporation or legal entity.

An alphabet soup of federal regulators just jointly issued new guidance “to clarify and consolidate existing regulatory expectations for obtaining beneficial ownership information for certain accounts and customer relationships.” The Financial Crimes Enforcement Network, Federal Reserve System, Federal Deposit Insurance Corporation, National Credit Union Administration, Office of the Comptroller of the Currency, Office of Thrift Supervision, Securities and Exchange Commission, and Commodity Futures Trading Commission all joined in the guidance.

Identifying the ownership and control of a legal entity can be difficult. Often, the only way to get the information is from the entity itself, with no third party way to identify the veracity of the information. Most financial institutions struggle with how far to dive into a legal entity to determine the beneficial ownership.

This joint guidance effectively adopts the FinCEN definition of beneficial owner:

“[T]he individual(s) who have a level of control over, or entitlement to, the funds or assets in the account that, as a practical matter, enables the individual(s), directly or indirectly, to control, manage, or direct the account. The ability to fund the account or the entitlement to the funds of the account alone, however, without any corresponding authority to control, manage, or direct the account (such as in the case of a minor child beneficiary), does not cause the individual to be a beneficial owner.” [31 CFR 103.175(b)]

The first step is to obtain enough information about the structure and ownership of the entity so you can determine if the account will pose a heightened risk. With a heightened risk, you should conduct enhanced due diligence.

Accounts for senior foreign political figures always require Enhanced Due Diligence that is reasonably designed to detect and report transactions that may involve the proceeds of foreign corruption. [31 CFR 103.178 (b)(2) and (c)]

The one interesting statement is that financial institutions should consider implementing policies on an enterprise-wide basis to share information about beneficial ownership of their customers. Anti-money laundering staff should be able to cross-check for information with other departments. Avoid silos of information.

The guidance does not offer anything new or insightful. But it is good to see the regulators joining together to try to standardize the expectations across different types of financial institutions.

Sources:

Image is by AlwaysAwake: Money Laundering: Hiding ownership and profits in offshore jurisdictions using myriad mechanisms in Switzeland, money laundering capital of the world, & other islands and nations. Favorite tool of mega-rich arch-criminal banking & corporate investors

Federal Regulators Issue Final Model Privacy Notice Form

Eight federal regulatory agencies today released the final model privacy notice form. It’s supposed to make it easier for consumers to understand how financial institutions collect and share information about consumers. Under the Gramm-Leach-Bliley Act, institutions must notify consumers of their information-sharing practices and inform consumers of their right to opt out of certain sharing practices. The two model form issued today can be used by financial institutions to comply with these requirements. One form allows consumers to opt out of sharing of personal information. The other form has no opt-out.

Back in April, the Securities and Exchange Commission reopened the period for public comment because they tested the model notices and found weaknesses with the current form.

The final model privacy form was developed jointly by the Board of Governors of the Federal Reserve System, Commodity Futures Trading Commission, Federal Deposit Insurance Corporation, Federal Trade Commission, National Credit Union Administration, Office of the Comptroller of the Currency, Office of Thrift Supervision, and Securities and Exchange Commission. There is also a joint release of the rule that goes along with the Final Model Privacy Form under the Gramm-Leach-Bliley Act

References: