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
For
additional commentary on developments in compliance and ethics, visit Compliance Building,
a blog hosted by Doug Cornelius.
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