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.

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.

Sources:

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.

 

 

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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