CFTC Proposes Amendments to Conditional Exemptions for Commodity Pool Operators and Commodity Trading Advisors

On October 2, 2023, the Commodity Futures Trading Commission (CFTC) published a notice of proposed rulemaking that would amend CFTC Rule 4.7, which provides limited exemptions for registered commodity pool operators (CPOs) and commodity trading advisors (CTAs) in respect of pools comprised solely of “Qualified Eligible Person” (QEP) participants, to:

(i) Impose certain minimum disclosure requirements for 4.7 pools and trading programs (4.7 Funds) operated and offered by CPOs and CTAs (Minimum Disclosure Proposal);

(ii) Increase the financial thresholds in the “Portfolio Requirement” which a QEP would be required to satisfy, to reflect inflation (QEP Thresholds Proposal); and

(iii) Codify certain CFTC exemptive letters permitting CPOs of 4.7 Funds that are “fund of funds” to distribute monthly account statements within 45 days of the month-end, provided that the CPO notifies pool participants of this alternative distribution schedule (FOF Relief Proposal).[1]

I. BACKGROUND

The U.S. Commodity Exchange Act (CEA) defines “commodity pool” as any investment trust, syndicate or similar form of enterprise operated for the purpose of trading commodity interests (i.e., swaps, futures and other derivatives regulated by the CFTC). The CEA and CFTC regulations do not regulate commodity pools directly; instead, they regulate operators of such pools which it defines as Commodity Pool Operators (CPOs[2]) and persons in the business of providing advice on trading in commodity interests to others, which it defines as Commodity Trading Advisers (CTAs[3]). 

CPOs and CTAs are required to register with the CFTC, unless an exemption or exclusion from registration is available.[4]  Registered CPOs and CTAs are subject to extensive ongoing compliance obligations under Part 4 of the CFTC’s regulations, including proficiency requirements for associated persons (APs), disclosure, reporting, and recordkeeping requirements.

Rule 4.7 provides limited relief to registered CPOs and CTAs that do not meet the requirements for an exemption or exclusion from registration.  Specifically, current Rule 4.7 exempts CPOs and CTAs from certain of the disclosure, reporting and recordkeeping requirements that would apply under Part 4 so long as their prospective and actual pool participants and advisory clients are restricted to QEPs.  However, Rule 4.7 does not exempt APs of registered CPOs from the requirement to register as such with the National Futures Association and to satisfy the National Commodity Futures Examination, nor does it exempt registered CPOs from periodic financial reporting requirements under CFTC Rule 4.27.  As a result, the utility of the exemption currently afforded to CPOs (in particular CPOs of offshore funds) is limited, especially when compared to the CFTC Rule 4.13(a)(3) exemption which does not require AP registration or periodic financial reporting. 

In order to qualify as a QEP, a person or institution must generally (i) be a professional financial intermediary or qualified purchaser, (ii) meet the requirements of an accredited investor[5] and satisfy certain minimum investment thresholds (Portfolio Requirement), (iii) be closely affiliated with an exempt pool, CPO or CTA, or (iv) be an entity in which all of the unitholders or participants are QEPs.

Since the adoption of Rule 4.7 in August 1992, the CFTC has not sought to narrow the scope of exemptions under Rule 4.7.  However, in the Proposal, the CFTC stated its “preliminary view that certain aspects of Regulation 4.7 no longer align with the Commission’s intentions,” and proposed three substantive amendments to Rule 4.7 discussed below, as well as technical amendments to Part 4. 

II. PROPOSAL

1. New Minimum Disclosure Requirements

The most significant aspect of the CFTC’s proposed changes would be the Minimum Disclosure Proposal, which would require CPOs and CTAs relying on Rule 4.7 to provide and keep current certain mandatory disclosure. 

In justifying the Minimum Disclosure Proposal, the CFTC highlighted:

(i) QEPs, in particular natural person QEPs, are not able to receive adequate information about the investment programs of 4.7 Funds as they do not have the requisite bargaining power;

(ii) There has been a significant expansion and growth in the complexity and diversity of commodity interest products offered to QEPs via 4.7 Funds, as well as an expansion in the asset classes subject to the CFTC’s jurisdiction and oversight, since Rule 4.7 was adopted. Specifically, the CFTC underscored the growth in the over-the-counter (OTC) swap market and the recent development of the digital assets market;

(iii) Market structure developments have enabled investors to access the commodity interest market without intermediating futures commission merchants (FCMs), which traditionally serve as independent sources of information available to 4.7 Fund participants;

(iv) Many CPOs and CTAs are already providing disclosures regarding 4.7 Funds to QEP investors that typically include much of the information the CFTC is proposing to require; and

(v) The new disclosures and associated recordkeeping requirements would facilitate more effective oversight of registered CPOs and CTAs and their offerings by the CFTC and National Futures Association (NFA) by providing an increased level of transparency into registrants’ activities for examination and enforcement purposes, thereby further deterring CPOs or CTAs from engaging in fraud or providing misleading representations.

Market participants who wish to comment on the Minimum Disclosure Proposal should consider the merits of each of the CFTC’s stated justifications for imposing minimum disclosure requirement on CPOs and CTAs in respect of 4.7 Funds, including by providing data and insights regarding the current disclosure investors in 4.7 Funds commonly receive as well as the practical utility of such disclosure to QEPs.  In this regard, Commissioner Summer K. Mersinger noted in her dissenting statement[6] the limited evidence the CFTC included in support of its preliminary views on the need for the Minimum Disclosure Proposal.

The specific new requirements that would be introduced under the Minimum Disclosure Proposal are as follows:

Disclosure Requirements for CPOs Regarding Rule 4.7 Pools

The Proposal would require CPOs to deliver to their 4.7 Funds’ prospective participants descriptions of the fund’s principal risk factors, its investment program, use of proceeds, custodians, fees and expenses, conflicts of interest, and certain performance disclosures, including past performance.  Specifically:

• Principal risk factors, including, without limitation, risks relating to volatility, leverage, liquidity, counterparty creditworthiness, as applicable to the types of trading programs to be followed, trading structures to be employed and investment activity (including retail forex and swap transactions) expected to be engaged in by the offered pool;[7]
• Investment program and use of proceeds, including the types of commodity interests and other interests which the pool will trade in (including, where applicable, the custodian or other entity that will hold such interests, and any non-U.S. jurisdiction in which such interests or assets will be held), a description of the trading and investment programs and policies, a summary description of the pool’s major CTAs, a summary description of the pool’s major investee pools or funds, and certain use of proceeds information (including the manner in which the pool will fulfill its margin requirements, the percentage of the pool’s assets held in segregation pursuant to the CEA, and information regarding whom income from margin or security deposits will be paid);[8]
• Fees and expenses, including a complete description of each fee, commission, and other expense, which the CPO knows or should know has been incurred by the pool for its preceding fiscal year and is expected to be incurred by the pool in its current fiscal year;[9]
• Potential or actual conflicts of interest, including a full description of such conflicts regarding any aspect of the pool on the part of: (1) the CPO; (2) the pool’s trading manager, if any; (3) any major CTA; (4) the CPO of any major investee pool; (5) any principal of the foregoing; and (6) any other person providing services to the pool, soliciting participants for the pool, acting as a counterparty to the pool’s retail forex or swap transactions, acting as intermediary or acting as a swap dealer with respect to the pool, as well as any other material conflict involving the offered pool;[10] and
• Performance disclosures, including certain information regarding past performance of the 4.7 Fund (but note that such information is not required regarding pools operated by the CPO other than the particular 4.7 Fund(s))[11].

The most burdensome aspects of the new disclosure requirements under the Minimum Disclosure Proposal—which are unlikely to be covered by existing offering materials of 4.7 Funds—include: (i) the break-even fee and expense analysis under CFTC Rule 4.24(i), which must be presented in a table format, and (ii) capsule performance disclosures under CFTC Rule 4.25, which requires past performance data.

Disclosure Requirements for CTAs Regarding 4.7 Trading Programs

The Proposal would require CTAs to deliver to clients of their 4.7 Funds descriptions of certain persons to be identified, the principal risk factors of the investment, the CTA’s trading program, fees, conflicts of interest, and performance disclosures.  Specifically, the following would need to be provided:

• Identities of Specified Persons, including each principal of the CTA, the FCM and/or retail foreign exchange dealers (“RFED”) with which the CTA will require its client to introduce its account (or, if the client is free to choose which FCM, FRED, or introducing broker it uses, then a statement to that effect);[12]
• Principal risk factors, including, without limitation, risks due to volatility, leverage, liquidity, and counterparty creditworthiness, as applicable to the offered trading program and the types of transactions and investment activity expected to be engaged in pursuant to such program (including retail forex and swap transactions, if any);[13]
• Trading program, including (1) the method chosen by the CTA concerning how FCMs and/or RFEDs carrying accounts it manages treat offsetting positions (if other than a first-in, first-out basis); and (2) the types of commodity interests and other interests the CTA intends to trade, with a description of any restrictions or limitations on such trading established by the CTA or otherwise;[14]
• Description of fees, including the dollar amount of each fee, wherever possible, and additional detail and explanation of certain fees, where the fees are dependent on specifically listed base amounts, or on any increase in a client’s commodity interest account;[15]
• Potential or actual conflicts of interest, including a full description of any actual or potential conflicts of interest regarding any aspect of their trading programs on the part of: (1) the CTA; (2) any FCM and/or RFED with which the client will be required to maintain its commodity interest account; (3) any introducing broker through which the client will be required to introduce its account to an FCM and/or RFED; and (4) any principal of the foregoing, within their Disclosure Documents, as well as any other material conflicts involving any aspect of the offered trading programs and any certain specified direct or indirect arrangements where the CTA or any principal thereof may benefit;[16] and
• Performance disclosures, including information on past performance for each relevant trading strategy.[17]

Disclosures regarding Non-4.7 Pools and Trading Programs

The Proposal would also remove the exemption for CPOs and CTAs from disclosing the past performance of 4.7 Funds in the disclosure documents of non-4.7 Funds. 

The Proposal would not only require CPOs and CTAs relying on Rule 4.7 to create minimum disclosure in respect of 4.7 Funds, but also to update the disclosures in respect of non-4.7 Funds operated or advised by the same CPOs and CTAs to include past performance information regarding 4.7 Funds.  For some CPOs and CTAs, reproducing historical trading information in the required format would result in significant cost.

Books and Records

The Proposal would require CPOs and CTAs to keep current the required disclosures regarding 4.7 Funds, maintain such disclosures as business records, and make them available to the CFTC, NFA, and the U.S. Department of Justice.

As a practical matter, the disclosure materials of 4.7 Fund would have to be updated at least every 12 months, and performance information could not be more than three months old as of the date the disclosure materials are made available. 

The new disclosure requirements would also give rise to increased enforcement and litigation risk for CPOs/CTAs[18] relying on 4.7.  Given such risk, along with the detailed disclosure specifications and obligations to keep disclosures current, the Minimum Disclosure Proposal would further reduce the utility of exemptions under Rule 4.7 and may incentivize funds to reduce or eliminate commodity interest activity in order to seek exemptions from CPO/CTA registration.

2. QEP Portfolio Requirement Thresholds

Rule 4.7 requires certain persons to be subject to a “Portfolio Requirement” to be a QEP. Currently, a person can satisfy the Portfolio Requirement by:

(i) owning securities (including pool participations) of issuers not affiliated with such person and other investments with an aggregate market value of at least $2 million (Securities Portfolio Threshold);

(ii) Having on deposit with an FCM, for its own account at any time during the six months preceding either the date of sale to that person of a pool participation in the 4.7 Fund or the date the person opens an exempt account with the CTA, at least $200,000 in exchange-specified initial margin and option premiums, together with required minimum security deposit for retail forex transactions for commodity interest transactions (Initial Margin and Premium Threshold); or

(iii) Owning a portfolio comprised of a combination of the funds or property specified in the Securities Portfolio Test and the Initial Margin and Premium Test, which, when expressed as percentages of the required amounts, meet or exceed 100%.

The QEP Thresholds Proposal would double the Securities Portfolio Threshold from $2 million to $4 million, and the Initial Margin and Premium Threshold from $200,000 to $400,000.[19] A person could still meet the Portfolio Requirement through a combination of the two tests.

The CFTC clarified that CPOs and CTAs would not be forced to effect mandatory redemptions or terminations of advisory relationships for investors that would cease to be QEPs due to the increase of thresholds, because under Rule 4.7(a)(3), QEP status is assessed at the time of sale of any pool participation units or when a person opens an exempt account.  However, as Commissioner Mersinger noted, the CFTC did not clarify whether formerly eligible QEPs would be able to make additional investments in exempt pools in which they are currently participating.

3. Codifying Exemptive Relief for Fund-of-Funds

Rule 4.7(b)(3) currently exempts CPOs relying on it from providing monthly account statements to pool participants, but instead requires CPOs to provide account statements at least quarterly within 30 days of the end of each quarter.  Operators of “fund of funds” have obtained no-action relief in the past to follow an alternative account statement schedule because they cannot control the timing of when they receive information from the investee funds, which often results in the investor fund CPO not receiving the requisite information for its own 4.7 pool reporting until close to the quarterly reporting deadline.

The FOF Relief Proposal would codify existing no-action letters and allow CPOs of fund of funds to send monthly account statements within 45 days of the end of each month, provided that that the CPO notifies pool participants of such alternative distribution schedule.

III. REQUESTS FOR COMMENTS

The CFTC has invited comment on a number of questions related to the Proposal. The questions, reproduced in Appendix A, touch on a number of issues identified in the Proposal, including: (i) how to measure the increase to the Portfolio Requirement; (ii) the impact of the increased Portfolio Requirement; (iii) how current CPOs and CTAs relying on Rule 4.7 disclose information to participants and clients; (iv) current and anticipated costs for compliance with Rule 4.7; (v) commenter proposals for alternative approaches to Rule 4.7; (vi) the operation of CPOs of fund of funds; and (vii) antitrust considerations.

In her dissenting statement, Commissioner Mersinger criticized the questions posed in the Proposal.  She noted that the list of questions does not address whether universal disclosures to QEPs should even be required, whether QEPs below the increased Portfolio Requirement thresholds would be permitted to make additional investments in a Rule 4.7 exempt commodity pool, and whether the CFTC should utilize its resources to review mandatory disclosures to QEPs. Commissioner Mersinger requested comment on her own list of questions regarding the Proposal addressing these and other issues. These questions, reproduced in Appendix B, are open for comment by all market participants, but are especially directed at QEPs.

Comments on the Proposal must be received on or before December 11, 2023.

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[1] 88 Fed. Reg. 70852 (Oct. 12, 2023).

[2] CPO is defined as “any person engaged in a business that is of the nature of a commodity pool, investment trust, syndicate, or similar form of enterprise, and who, with respect to that commodity pool, solicits, accepts, or receives from others, funds, securities, or property, either directly or through capital contributions, the sale of stock or other forms of securities, or otherwise, for the purpose of trading in commodity interests.” CEA section 1a(11).

[3] CTA is defined as “any person who, for compensation or profit, engages in the business of advising others, either directly or through publications, writing, or electronic media, as to the value of or the advisability of trading in commodity interests.” CEA section 1a(12).

[4] For CPOs, common exemptions include those under CFTC Rule 4.13(a)(3) and related no-action relief under CFTC No-Actin Letter 12-38.  For CTAs, common exemptions include those under CEA Section 4m(3) and CFTC Rule 4.14(a)(5), (a)(8), and (a)(10). 

[5] 17 CFR § 230.501(a).

[6] See Dissenting Statement of Commissioner Summer K. Mersinger On Proposal to Narrow Historical Exemptions for Qualified Eligible Persons in Rule 4.7, Commodity Futures Trading Comm’n (Oct. 2, 2023), https://www.cftc.gov/PressRoom/SpeechesTestimony/mersingerstatement100223.

[7] CFTC Rule 4.24(g).

[8] CFTC Rule 4.24(h).

[9] CFTC Rule 4.24(i).

[10] CFTC Rule 4.24(j).

[11] CFTC Rule 4.25 (other than Rule 4.25(a)(3) or (c)(2)).

[12] CFTC Rule 4.34(e).

[13] CFTC Rule 4.34(g).

[14] CFTC Rule 4.34(h).

[15] CFTC Rule 4.34(i).

[16] CFTC Rule 4.34(j).

[17] CFTC Rule 4.35.

[18] The CEA creates private rights of actions for persons who purchased an interest or participation in a commodity pool or who received commodity trading advice in connection with a violation of the CEA by the relevant CPO/CTA .  See 7 U.S.C. Section 25. 

[19] The CFTC justified doubling the thresholds data from two inflation indices over the past 30 years (specifically, the Consumer Price Index for All Urban Consumers and the Consumer Price Index for Urban Wage Earners and Clerical Workers, each as published by the United States Bureau of Labor Statistics).