The US Commodities Futures Trading Commission (CFTC) recently proposed new rules that, among other actions, update the definition of a “qualified eligible person,” add minimum disclosure requirements for certain pools and trading programs, and permit monthly account statements for “fund of funds” to be delivered within 45 days instead of 30.
Commodity pool operators (CPOs) and commodity trading advisors (CTAs) that are unable to avail themselves of an exemption under CFTC Regulation 4.7 are subject to onerous disclosure, reporting, and recordkeeping requirements. The Regulation 4.7 exemption can be claimed by CPOs and CTAs that offer their pools or trading programs to investors who are considered “qualified eligible persons” (QEPs).
BACKGROUND
The standard for determining whether an investor is a QEP is based on the investor satisfying investor status criteria enumerated in the regulation and/or satisfying a “Portfolio Requirement,” which has remained constant since the regulation’s introduction in 1992.
The Portfolio Requirement includes two thresholds that investors may satisfy separately or by meeting a combination of the two—owning securities with an aggregate market value of at least $2 million and having at least $200,000 in exchange-specified initial margin and option premiums, together with any retail forex security deposits, on deposit with a futures commission merchant (FCM) for its own account at any time during the prior six months before investing in a 4.7 pool or opening a 4.7 account.
The CFTC’s proposed rulemaking (the Proposal) would
- double the Portfolio Requirement threshold (i.e., require investors to own $4 million in securities or have on deposit with an FCM for its own account at least $400,000 in initial margin, option premiums, or retail forex security deposits, or satisfy a combination of these two requirements);
- require CPOs and CTAs relying on Regulation 4.7 to provide uniform disclosures to QEPs;
- codify routinely issued exemptive letters allowing CPOs of fund of funds operated pursuant to Regulation 4.7 to choose to distribute monthly account statements within 45 days of the month end; and
- make other technical amendments to Regulation 4.7.
The CFTC’s proposed amendments are based on information from a 2014 staff roundtable on CPO risk management practices that led the CFTC to conclude that natural persons who satisfy the QEP definition “likely lack the ability” to request more disclosure and transparency regarding their investments in 4.7 pools or accounts.
The CFTC also explains that the Proposal is necessary because commodity interest markets have become more complex now that swaps are part of the CFTC’s jurisdiction and because of accelerated product innovation.
Comments on the Proposal are due by December 11, 2023.
PROPOSED DISCLOSURE REQUIREMENTS
Proposed QEP Disclosure Requirements for CPOs
The CFTC has proposed that CPOs of 4.7 pools provide “QEP Disclosures” that are tailored to include “the most meaningful and important information for prospective QEP pool participants.” Essentially, the Proposal would require CPOs of 4.7 pools to provide substantially the same type and level of disclosures as CPOs of non-4.7 exempt pools with certain exceptions.
While it is commonplace for CPOs of 4.7 pools to include in the pools’ private placement memoranda (PPMs) some of the proposed QEP Disclosures—such as descriptions of risk factors, a pool’s investment objective, fees and expenses, conflicts of interest, use of proceeds, and identification of the custodian—many of the new QEP Disclosures are broader than what a CPO of a 4.7 pool would generally include in a PPM or are entirely new, such as the requirement to include a pool’s break-even point and past performance.
Break-Even Point
The Proposal would require a CPO to incorporate in a pool’s PPM the pool’s break-even point: that is, the trading profit that a pool must realize in the first year of a participant’s investment to equal fees and expenses such that the participant will recoup its initial investment, expressed both as a dollar amount and as a percentage of the minimum unit of initial investment and assuming redemption after the first year. The break-even point must be presented in a table format and be calculated consistent with CFTC and National Futures Association (NFA) requirements.
Past Performance
The Proposal would also require a CPO to include performance data in a pool’s PPM (only for the offered pool). Past performance data includes the rate of return for the pool annually for the five most recent calendar years and year to date, with monthly rates of return, and the largest monthly drawdown during the five most recent calendar years and year to date, among other things.
Unlike current practice whereby a CPO typically updates a 4.7 pool’s PPM when there is a material change to the pool’s investment program or the management of the pool, the Proposal would require a CPO to update its 4.7 pools’ PPMs at least every 12 months or more frequently upon material changes. In addition, past performance data may not be older than three months from the date of the PPM under the Proposal.
Proposed QEP Disclosure Requirements for CTAs
Under the Proposal, CTAs relying on Regulation 4.7 will be required to include disclosure of
- principal risk factors,
- conflicts of interest,
- past performance,
- fees,
- each principal of the CTA, any FCM or retail forex dealer with which the CTA will require its client to maintain an account, and any introducing broker through which the CTA will require the client to introduce its account, and
- a description of the trading program.
The trading program description must include the types of commodity interests and other interests the CTA intends to trade and any restrictions or limitations on such trading, as well as a description of the method the CTA uses to require its FCMs or retail forex dealers to treat offsetting positions (only if the method is not either closing out all offsetting positions or closing out on a first-in, first-out basis).
IMPLICATIONS FOR CPOS OF NON-4.7 POOLS
Generally, where a CPO may not avail itself of Regulation 4.7 and must comply with the full disclosure requirements of Part 4 of the CFTC’s regulations for a pool (i.e., a “non-4.7 pool”), the CFTC requires a non-4.7 pool’s disclosure document to include performance data of the offered pool and other pools offered by the CPO.
Currently, however, CPOs of both non-4.7 and 4.7 pools need not include the performance of 4.7 pools in the disclosure documents of non-4.7 pools. Under the Proposal, the CFTC would eliminate this exemptive relief. As such, CPOs of non-4.7 pools would need to include the past performance information of 4.7 pools (to the extent they manage 4.7 pools) in disclosure documents of their non-4.7 pools.
NO NFA FILING AND PREAPPROVAL REQUIREMENT
CPOs of non-4.7 pools must file with the NFA their disclosure documents for the NFA’s review and preapproval prior to first use, when they become materially inaccurate or incomplete, and annually. Currently, CPOs of 4.7 pools are exempt from this requirement, and the Proposal would leave this exemption in place.
Instead, the CFTC has proposed that the Commission and NFA monitor and assess the accuracy of QEP Disclosures compared to actual trading activities pursuant to existing examination procedures and to the comparison of information provided in Forms CPO-PQR and CTA-PR and other filings.
QEPS THAT NO LONGER SATISFY THE HEIGHTENED STANDARDS
Regulation 4.7(a)(3) requires that a CPO assess a person’s QEP status at the time of such person’s investment. CTAs must make a similar assessment at the time that a person opens an exempt account. The CFTC has proposed not to change this requirement to minimize the potential for disruption and possible negative consequences for current QEPs that may arise if the CFTC required mandatory redemptions or terminations of advisory relationships for current QEPs that would not satisfy the heightened standards.
Despite providing this guidance, the CFTC has asked for specific comment on the number of current QEPs that would not qualify as QEPs under the proposed amendments to the Portfolio Requirement and how much time CPOs and CTAs would need to determine whether current QEPs continue to satisfy the proposed Portfolio Requirement, if adopted.
Further, the CFTC did not address whether existing investors in a pool would need to meet the new definition of a QEP before making an additional investment in such pool. As CFTC Commissioner Summer K. Mersinger pointed out in her dissent, the CFTC will need to clarify this ambiguity if it moves forward with the rulemaking.
WHAT’S NEXT?
Commissioner Mersinger dissented from the issuance of the proposed rulemaking, in part because the support for imposing QEP disclosure requirements on CPOs and CTAs that rely on Regulation 4.7 is, in her view, “woefully insufficient.”
In contrast, CFTC Commissioner Kristin N. Johnson supported revisiting the requirements to confirm that they remain “fit for purpose,” explaining that the Proposal addresses regulatory gaps that now exist as a result of changing dynamics in the derivatives markets.
Commissioner Mersinger’s dissenting statement provides a roadmap for comments. For example, the CFTC’s basis for the Proposal is its conclusion that current market conditions and industry practices support the proposed QEP Disclosures for 4.7 pools and trading programs. The CFTC explains that commodity interest markets are more complex now as a result of swaps coming under the CFTC’s jurisdiction and accelerated product innovation.
However, 4.7 pools did not just start using swaps—they have used swaps in their trading strategies prior to the regulation of these instruments (which occurred more than a decade ago), and other regulators, such as the NFA, have addressed product innovation by introducing tailored disclosure requirements for new asset classes such as digital assets.
In contrast, the CFTC’s Proposal would address the assumed complexity in the markets by requiring CPOs and CTAs to provide QEPs with uniform risk and performance disclosures, among others. Although CPOs and CTAs may already disclose some of the QEP Disclosures to prospective and current investors or clients, other QEP Disclosures—such as providing five years of performance data and incorporating a break-even table into a 4.7 pool’s PPM—may be burdensome and will take time to incorporate.
CPOs and CTAs relying on Regulation 4.7 should analyze the impact of the heightened Portfolio Requirement and how the QEP Disclosures will affect their current disclosures and consider commenting on the Proposal.
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