This week’s BR Derivatives Report Regulatory Review focuses exclusively on a rule proposal issued by the U.S. Commodity Futures Trading Commission (“CFTC”) on October 2, 2023.
CFTC Rule Proposal to Amend Regulation 4.7
Type of Market Participant Involved
Registered Commodity Pool Operators (“CPOs”) and Commodity Trading Advisors (“CTAs”) relying on CFTC Regulation 4.7
Summary
The Commodity Exchange Act (“CEA”) regulates the entity or, in some cases, individuals responsible for the operation of an investment fund. In the language of the CEA, such an entity or individual is referred to as a “commodity pool operator” or CPO, while the investment fund itself is referred to as the “commodity pool.”
Similarly, the CEA regulates an investment adviser that provides advice for compensation or profit with respect to the purchase and sale of certain derivatives and other leveraged types of investments. Again, in the language of the CEA, such an adviser is a “commodity trading advisor” or CTA, while the derivatives and investments are called “commodity interests.”
The general regulatory architecture under the CEA involves the registration and substantive regulation of CPOs and CTAs through a myriad of disclosure, reporting, and recordkeeping obligations that apply to their investment and solicitation activities. Notably, the CFTC has issued its Regulation 4.7 to provide certain qualifying CPOs and CTAs relief from most of these obligations.
In order to claim the exemptive relief, CPOs and CTAs are required to restrict their pool participants and advisory clients to Qualified Eligible Persons (“QEPs”) as that term is defined in CFTC Regulation 4.7, register as a CPO or CTA with the CFTC and National Futures Association (“NFA”), and make certain filings with the NFA.
On October 2, 2023, the CFTC proposed rule amendments that, if adopted, will require CPOs and CTAs currently relying on CFTC Regulation 4.7 exemptive relief to:
- Provide their prospective pool participants and advisory clients with new disclosures, and satisfy “books and recordkeeping” requirements with respect to these disclosures; and
- Ensure that certain participants and investors meet increased monetary thresholds to satisfy the QEP Portfolio Requirement of CFTC Regulation 4.7.
More specifically, the proposed amendments to CFTC Regulation 4.7 will substantially change the disclosure and compliance oversight obligations of CPOs and CTAs in the following ways:
- CPO Disclosures: CPOs will be required to deliver to prospective QEP pool participants disclosures about the pool’s principal risk factors, its investment program, use of proceeds, custodians, fees and expenses, conflicts of interest, and certain performance disclosures, including basic past performance information. These disclosures will be subject to books and recordkeeping requirements and must be made available to the CFTC, the NFA, and the U.S. Department of Justice.
- CTA Disclosures: CTAs will be required to deliver to prospective QEP advisory clients disclosures about certain of the CTAs principals and aspects of its relationships with intermediaries such as a futures commission merchant or introducing broker. In addition, the CTA will be required to deliver disclosures about its trading program, fees, conflicts of interest, and performance disclosures. CTAs will also be required to satisfy books and recordkeeping requirements for these disclosures.
- Increased Monetary Thresholds for Certain QEPs: The Portfolio Requirement will be doubled for certain QEPs, including registered investment companies, business development companies, retirement plans with at least $5,000,000 in total assets, and natural persons who are “accredited investors,” as such term is defined by the Securities and Exchange Commission (“SEC”). Specifically, the “securities portfolio threshold“ will be increased from $2,000,000 to $4,000,000 and the “initial margin and premium threshold“ will be doubled from $200,000 to $400,000. It is important to emphasize that only specific types of pool participants and are required to satisfy the Portfolio Requirement to qualify as an QEP under Regulation 4.7.
Additionally, the CFTC has proposed revisions to CFTC Regulation 4.7 that will codify no-action relief previously granted in letters issued by the staff of the CFTC to “funds of funds.” In effect, recipients of such relief were permitted to distribute certain monthly statements within 45 days of month-end, instead of the 30-day month-end delivery period otherwise required by CFTC Regulation 4.7.
Commentary
The proposed disclosure requirements represent select aspects of existing requirements that apply to CPOs and CTAs offering services to Non-QEPs (i.e., prospective pool participants and clients that do not meet the QEP requirements).
Most CPOs and CTAs that rely on CFTC Regulation 4.7 deliver a disclosure document to their prospective pool participants and clients, respectively. However, it is not always—or perhaps even often—the case that a 4.7 CPO/CTA’s disclosure document is drafted with an eye toward the specific requirements that apply to Non-QEPs.
Accordingly, the recently proposed disclosure requirements are noteworthy for many—if not most—CPOs and CTAs that are currently relying on the exemptive relief available under CFTC Regulation 4.7.
Comments on the proposal must be received by the CFTC within 60 days of the publication of the proposal in the Federal Register (which did not yet occur at the time of publication of this article).
Bottom Line
The CFTC’s proposal comes at a time when private fund advisers—many of whom also operate in reliance on CFTC Regulation 4.7 exemptive relief—are analyzing their existing disclosures in light of the new “private fund adviser rules” adopted by the SEC in August 2023.
If an investment management firm finds itself at the crossroads of CFTC and SEC regulation, then the timing may be right to consider its existing disclosures in light of the proposed (CFTC) and newly adopted (SEC) disclosure requirements.
Also, 4.7 CPOs and CTAs may want to consider whether to file a comment letter on the CFTC’s proposed rule changes, either alone or as part of a trade association’s initiative.