K&L GATES LLP 2013 NEW YORK INVESTMENT MANAGEMENT CONFERENCE

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1 K&L GATES LLP 2013 NEW YORK INVESTMENT MANAGEMENT CONFERENCE CURRENT ISSUES IN CFTC REGULATION AND DERIVATIVES REGULATION: UPDATE AND PRACTICAL CONSIDERATIONS December 10, 2013 Cary J. Meer K&L Gates LLP 1601 K Street, NW Washington, D.C (202) cary.meer@klgates.com A. Commodity Pool Operators ( CPOs ) Definition. 1 Effective April 24, 2012, the Commodity Futures Trading Commission ( CFTC ) amended its regulations to rescind the exemption from CPO registration under CFTC Regulation 4.13(a)(4) for the operators of private funds that limit investors therein to highly sophisticated persons. The CFTC also rescinded the exemption from registration as a commodity trading advisor ( CTA ) under CFTC Regulation 4.14(a)(8) for persons who act as advisors to pools operated in accordance with CFTC Regulation 4.13(a)(4). The CFTC retained the CPO registration exemption under CFTC Regulation 4.13(a)(3), which limits the amount of commodity interest trading that a private fund may engage in, despite its having proposed to rescind that as well. Commodity Pool Operators and Commodity Trading Advisors: Compliance Obligations, 77 Fed. Reg (February 24, 2012); correction notice published at 77 Fed. Reg (March 26, 2012) ( Amendment Release ). The CFTC amendments became effective on April 24, Investment advisers to private funds that filed notices under CFTC Regulation 4.13(a)(4) prior to April 24, 2012 had until December 31, 2012 to register as CPOs or CTAs or rely upon a different exemption (such as CFTC Regulation 4.13(a)(3)). See the Division of Swap Dealer and Intermediary Oversight Responds to Frequently Asked Questions CPO/CTA: Amendments to Compliance Obligations (August 14, 2012, as amended) ( FAQ ) (answer to question 3 under the heading Regulation 4.13 ). Please note, however, that the term commodity interest includes swaps as of December 31, Accordingly, if the only commodity interests a person has been involved in are swaps, and the person is unable as of that date to claim an exemption from registration under, for example, CFTC Regulations 4.13(a)(3) or 4.14(a)(8), given the amount of swap activity in pools operated by the person or about which the person has provided advice, registration as a CPO or CTA was required as of December 31, See the FAQ (answer to question 4 under the heading Regulation 4.13 ). This outline is current as of October 22, K&L Gates LLP. All rights reserved. DC v

2 a. Pre-Dodd-Frank Act Definition. Section 1a(5) of the Commodity Exchange Act ( CEA ) defined a CPO as: any person engaged in a business that is of the nature of an investment trust, syndicate, or similar form of enterprise, and who, in connection therewith, 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 futures] on or subject to the rules of any contract market or derivatives transaction execution facility [ DTEF ]. CFTC Regulation 1.3(cc) expands the definition of CPO to include persons engaged in such business for the purpose of trading options on exchange-traded futures contracts. See CFTC Regulation 1.3(cc) (definition of CPO ); CFTC Regulation 1.3(hh) (definition of commodity option ). In addition, although the CEA and CFTC definitions of CPO do not refer to foreign futures or options, CFTC Regulation 30.4(c) effectively treats certain operators of pooled investment entities that trade in foreign futures or options as CPOs and requires them to register under the CEA in that category. b. Dodd-Frank Act Definition. Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act ) amended the definitions of CPO and CTA to, among other things, include swaps. 2 Title VII of the Dodd-Frank Act defines a CPO as: any person who is registered with the CFTC as a CPO or is engaged in a business that is of the nature of a commodity pool, investment trust, syndicate, or similar form of enterprise, and who, in connection therewith, 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, including any: 2 On July 10, 2012, the Securities and Exchange Commission (the SEC ) and the CFTC jointly adopted several final rules and provided interpretive guidance with respect to the definitions of the terms swap, securitybased swap, security-based swap agreement, and mixed swap. Further Definition of Swap, Security-Based Swap, and Security-Based Swap Agreement ; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 74 Fed. Reg (Aug. 13, 2012) (Release Nos and , July 18, 2012). See also Determination of Foreign Exchange Swaps and Foreign Exchange Forwards under the Commodity Exchange Act, 77 Fed. Reg. 69,694 (Nov. 20, 2012) (which is a written determination by the Secretary of the Treasury that certain foreign exchange forwards and swaps are not swaps for this purpose). 2

3 (i) (ii) (iii) (iv) commodity for future delivery, security futures product, or swap; agreement, contract, or transaction described in Section 2(c)(2)(C)(i) of the CEA or Section 2(c)(2)(D)(i) of the CEA; commodity option authorized under Section 4c of the CEA; or leverage transaction authorized under Section 19 of the CEA. c. Effective Date of the Dodd-Frank Act Definition. The effective date for the inclusion of swaps in what constitutes a commodity interest for purposes of the CPO definition was December 31, Regulatory Requirements. a. Registration Introduction. The CPO and its APs must register as such under the CEA. 4 The CPO must also become a member of the National Futures Association ( NFA ) and its APs must become associate members of NFA. NFA handles registration processing on behalf of CFTC. NFA converted from a paperbased to an online registration system ( ORS ) in June i. Who is the CPO? In making the CFTC Regulation 4.13(a)(4) exemption filings for private funds organized as corporations in non-united States jurisdictions, firms frequently listed the CPO as the investment adviser to the private fund. However, the CFTC s long-standing position is that the board of directors of a fund set up as a corporate entity is the CPO. The CFTC s Division of Swap Dealer and Intermediary Oversight ( DSIO ) has confirmed that the board of directors of a commodity pool may delegate its rights and 3 See the FAQ (answer to question 4 under the heading Regulation 4.13 ). 4 An AP of a CPO is defined as a natural person associated with a CPO as a partner, officer, employee, consultant, or agent (or any natural person occupying a similar status or performing similar functions), in any capacity which involves (i) the solicitation of funds, securities, or property for participation in a commodity pool or (ii) the supervision of any person or persons so engaged. CFTC Regulation 1.3(aa)(3). This means that marketing personnel, and persons who supervise marketing personnel up to and including a CPO s chief executive officer, may need to register as APs. CFTC Regulation 3.12(h) does, however, provide certain relief from AP registration. 3

4 obligations as a CPO to an investment adviser, provided that the investment adviser is qualified to serve as a CPO, is registered as a CPO and the board of directors agrees to remain jointly and severally liable with respect to any violations of the CEA. See the FAQ (answer to question 2 under the heading Who is the Commodity Pool Operator? ). In order to comply with the DSIO s recent guidance, advisers should prepare a delegation agreement for each private fund organized as a corporation in a non-united States jurisdiction whereby the board of directors delegates its rights and obligations, particularly with respect to registration as the CPO and compliance with the CEA and the CFTC regulations, and agrees to remain jointly and severally liable with the adviser with respect to any violations of the CEA. 5 In making the CFTC Regulation 4.13(a)(4) exemption filings for private funds organized as limited partnerships or limited liability companies, the CPO is generally the general partner or the managing member. As long as the investment adviser itself is the general partner or managing member, delegation agreements are not required in order to comply with the DSIO s recent guidance. If the investment adviser serves as the investment adviser or investment manager to the fund, and there is a separate special purpose general partner or managing member, delegation agreements may be required if the investment adviser is to serve as the CPO. ii. Principals. The CPO must also list its principals on its registration application. A principal is generally, for a corporation, the president, chief executive officer, chief operating officer, chief financial officer and chief compliance officer (collectively, executive officers ), any director, any person in charge of a principal business unit, division or function subject to regulation by the CFTC; the executive officers, managers or managing members of a limited liability company or limited liability partnership and those members vested with the management authority for the entity, and any person in charge of a principal business unit, division or function subject to regulation by the CFTC; any general partner and the chief compliance officer of a partnership; and any person occupying a similar status or performing similar functions, having the power, directly or indirectly, through agreement or otherwise, to exercise a controlling influence over the entity s activities that are subject to regulation by the CFTC. Additionally, a principal 5 In addition to preparing a delegation agreement for each fund, it may be necessary to obtain individualized no-action relief from the CFTC staff each time the CPO function is delegated. We have discussed whether this relief is required with the staff of the DSIO in light of the answer to question 2 in the FAQ. We understand that the staff is considering whether relief is truly required or whether more general no-action relief may be issued by the DSIO. We hope that this issue will be resolved in the next couple of months. 4

5 includes any natural person who, directly or indirectly, owns, is entitled to vote, or has the power to sell or direct the sale of, 10% or more of any class of voting securities, 6 or is entitled to receive 10% or more of the profits of the entity, or who has the power to exercise a controlling influence over the entity s activities that are subject to regulation by the CFTC. A principal also includes any person, other than a natural person, that is the direct owner of 10% or more of the voting securities of the entity. Furthermore, any person who has contributed 10% or more of the capital of the entity is a principal, except for unaffiliated banks or insurance companies that contribute capital through subordinated debt that is not guaranteed by another party not listed as a principal. Finally, the definition of principal includes any natural person who, directly or indirectly, creates or uses a trust, proxy, power of attorney, pooling arrangement or any other contract, arrangement, or device with the purpose or effect of divesting such person of direct or indirect ownership of a voting security of the entity, or preventing the vesting of such ownership, or of avoiding making a contribution of 10% or more of the capital of the entity, as part of a plan or scheme to evade being deemed a principal of the entity. CFTC Regulation 3.1(a). iii. Applications. Applicants for registration as a CPO and membership in NFA must file Form 7-R and must submit a Form 8-R for each AP and natural person principal. 7 The Form 8-R must include a fingerprint card, which will be sent to the Federal Bureau of Investigation as part of the determination of the person s fitness. As part of the application for an AP, the applicant must submit a Sponsor s Certification stating that the sponsor intends to employ the applicant as an AP and will do so within 30 days after the registration is granted, that the sponsor has verified the information supplied by the applicant as to his or her education and employment history during the preceding three years, and that all 6 The CFTC has clarified that the ownership threshold regarding securities does not include non-voting securities. However, between the proposal and adoption of final regulations, the CFTC added to paragraph (a)(2)(i) of the principal definition in CFTC Regulation 3.1 the phrase or has the power to exercise a controlling influence over the entity s activities that are subject to regulation by the Commission. There is essentially identical language in paragraph (a)(1) of CFTC Regulation 3.1, which pertains to persons occupying certain roles at a registrant. The CFTC explained that it added the quoted language to capture an owner who might indirectly have the power such as through a membership agreement to dictate upfront the entity s activities subject to CFTC regulation. 77 Fed. Reg , (August 28, 2012). 7 Note that NFA Bylaw 301(iii) states that a firm will not be registered as a CPO unless at least one person is both a principal and an AP. 5

6 of the information supplied by the applicant on the form is, to the best of the sponsor s knowledge, accurate and complete. iv. Proficiency Examination Requirements. Generally, APs must satisfy proficiency requirements by taking and passing the National Commodity Futures Examination (Series 3), unless they have taken and passed the exam within the previous two years or, since having passed the exam, there has not been a period of two consecutive years in which they have not been registered as an AP or as a floor broker. 8 Applicants may satisfy the proficiency requirements by taking an exam other than the Series 3, if they meet the appropriate qualifications. 9 1.) For example, individuals registered as General Securities Representatives (Series 7) that limit their futures activities on behalf of their sponsors to soliciting customers for participation in a commodity pool, or for discretionary accounts to be managed by CTAs, may take the Futures Managed Funds Examination (Series 31) instead of the Series 3 exam. The Series 31 alternative is not available to a Series 7 representative of an affiliate of the CPO; rather the Series 7 must be held by the CPO, which would require the CPO to be a registered broker-dealer. 2.) Individuals may use the Limited Futures Examination (Series 32) if, within the two years prior to filing the application, they have been registered or licensed to solicit customer business in futures in the United Kingdom or Canada. 3.) Individuals are not required to take an examination if they are registered with FINRA as a General Securities 8 Every location from which sales activity is conducted that is not the headquarters of a firm is generally considered a branch office and generally must have a branch office manager. See NFA Interpretive Notice 9002: Registration Requirements; Branch Offices (Staff: September 6, 1985; revised July 1, 2000; December 9, 2005; and September 30, 2010). In addition to Series 3, the branch office manager is generally required to pass the Series 30 examination within the two years preceding his application. However, a person may not be required to take the Series 30 examination if: (i) he is currently approved as a branch office manager; or (ii) he was approved as a branch office manager and, since the last date the applicant was withdrawn as a branch office manager, there has not been a period of two consecutive years during which he was not either temporarily licensed as an AP or registered as an AP; or (iii) his sponsor is a registered securities broker-dealer that provides proof that the person is qualified to act as a branch office manager or designated supervisor under rules of the Financial Industry Regulatory Authority, Inc. ( FINRA ). 9 In addition, the NFA appears in some circumstances to be allowing persons whose Series 3 license has lapsed for more than two years to take the Series 32 examination rather than the Series 3 examination, upon written request to the NFA describing the circumstances. 6

7 Representative with their sponsor and they are going to limit their futures activities on behalf of their sponsor to referring clients to APs of the sponsor, which referrals are solely incidental to their business as a General Securities Representative, or supervising persons who perform these same limited activities. See NFA Registration Rule 401(b). 4.) The NFA s Director of Compliance will, upon request, grant waivers from the Series 3 examination requirement to individuals associated with CPOs if: a.) b.) c.) the CPO or the pool is subject to regulation by a federal or state regulator, or the pool is privately offered pursuant to an exemption from the registration requirements of the Securities Act of 1933, as amended ( Securities Act ), and the CPO limits its activities to operating a pool that (1) engages principally in securities transactions, (2) commits only a small percentage of its assets as initial margin deposits and premiums for futures and options on futures, and (3) uses futures and options on futures only for hedging or risk management purposes; or the individual requesting the waiver is a general partner of a CPO or a pool that is primarily involved in securities investments; there is at least one registered general partner of the CPO or pool who has taken and passed the Series 3 examination; and the person requesting the waiver is not involved in soliciting or accepting pool participations, trading futures or options, handling customer funds, or supervision of these activities or engaging in any other activity that is integral to the operation of the fund as a pool. NFA Interpretive Notice 9018: Registration Rule 402: CPOs of Pools Trading Primarily in Securities (Board of Directors: August 1, 1992; revised December 10, 2007). NFA Registration Rule 401(e) provides that, if the only commodity interests a firm trades are swaps, then the APs of that firm will be eligible for an automatic examination waiver. To the extent that a firm engages in other commodity interest trading activities in addition to swaps, and if trading swaps is what triggers the firm s CPO registration obligation (i.e., but for trading in swaps, the firm 7

8 would satisfy the trading limits under Regulation 4.13(a)(3)), the firm can apply for an examination waiver for particular APs only involved in marketing pools where swaps are what cause registration to be required. This examination waiver is initially temporary and only available until the NFA develops an examination for swaps. However, it may become a permanent exemption. Alternatively, persons relying on the waiver in connection with January 1, 2013 registrations may be grandfathered. NFA Notice I (October 3, 2012). b. Disclosure. The CPO must furnish a disclosure document ( Disclosure Document ) to each prospective pool participant by no later than the time it delivers to the prospective participant a subscription agreement for the pool. CFTC Regulation This Disclosure Document must contain, among other things, actual performance information for the offered pool for the most recent five calendar years and year-to-date, or the life of the pool, whichever is shorter. If the offered pool has traded commodity interests for at least three years in which 75% or more of the contributions to the offered pool were made by persons unaffiliated with the CPO, the trading manager (if any), the pool s CTAs, or the principals of any of the foregoing, only past performance of the offered pool is required. A pool s trading manager is a person other than the CPO who has sole or partial authority to allocate pool assets to CTAs or investee pools. CFTC Regulation 4.10(h). If the pool has less than a three-year operating history, performance information must be supplied for other persons and entities as well. This includes the performance of other pools and managed accounts operated or traded by the CPO and the trading manager of the offered pool, if there is a trading manager; however, if the trading manager has been delegated complete authority over the offered pool s trading, and the trading manager s performance is not materially different from that of the CPO, the performance of the other pools operated, and managed accounts traded, by the CPO need not be disclosed. If the CPO and trading manager do not have a three-year history, then performance of the trading principals of the CPO must also be disclosed, unless such performance does not differ materially from the performance of the offered pool, CPO and trading manager that is disclosed in the Disclosure Document. If the 10 The Harmonization Release (as defined in Section A.2.d below) rescinded the requirement for all CPOs to obtain a signed acknowledgement of receipt of the Disclosure Document from each pool participant, effective August 22,

9 CPO, its trading principals, and the trading manager have never operated pools or traded managed accounts before, that must be prominently disclosed. Disclosure is also required of performance of accounts, including pools, traded by a major CTA (a CTA that is allocated 10% of pool funds available for trading) and major investee pools, which include any pool that is allocated at least 10% of the net asset value of the investor pool. CFTC Regulation 4.25(a)(5), (b), (c). The Disclosure Document generally must be filed electronically with NFA and pre-cleared by NFA, and updated every twelve months. CFTC Regulation 4.26(a)(2), (d). 11 c. Reporting. The CPO must furnish to each pool participant certain prescribed reports. Electronic means may be used if the CPO first discloses its intent to use such means and the participant fails to object within ten business days of such disclosure. CFTC Regulation If the CPO is unable to meet the reporting deadline, it must request an extension from the CFTC and NFA under CFTC Regulation Under CFTC Regulation 4.22(f)(1), a CPO may receive up to an additional 90 calendar days to send the audited financial statements. A CFTC Regulation 4.22(f)(1) application provides relief on a one-time basis and requires a letter from the CPO s accountants. Under CFTC Regulation 4.22(f)(2), CPOs of commodity pools that invest in other collective investment vehicles may obtain an automatic 90-day extension of the distribution and filing due date by submitting an application to the NFA prior to the original due date. A CFTC Regulation 4.22(f)(1) application need only be made once per pool. d. Recordkeeping. Until recently, the CPO was required by CFTC Regulation 4.23 to keep, at its main business office, accurate books and records regarding each pool it operates. These books and records are prescribed by regulation and are subject to inspection by the CFTC, NFA, and the U.S. Department of Justice. However, on August 13, 2013, the CFTC adopted final rules implementing harmonization of compliance obligations for registered investment companies ( RICs ), which were published in the Federal Register on August 22, 2013 (the Harmonization Release ). 12 In the Harmonization Release, the CFTC also granted recordkeeping relief to 11 The Harmonization Release amended the requirement that the Disclosure Documents be updated every nine months and provided for a twelve month cycle instead, effective September 23, Harmonization of Compliance Obligations for Registered Investment Companies Required to Register as Commodity Pool Operators, 78 Fed. Reg (Aug. 22, 2013), available at: 9

10 CPOs of private funds. Accordingly, CFTC Regulations 4.23 and 4.7(b) were amended by the Commission to delete the requirement that books and records be kept at the main business location of the CPO. All CPOs are now allowed to use third-party service providers to manage their recordkeeping obligations, provided that, if the CPO does so, the CPO notifies the CFTC through the NFA as required under amended CFTC Regulation 4.23(c). Additionally, the records must be available for inspection within 48 hours (72 hours if held outside the United States). 13 e. Separate Legal Entity. A CPO must operate each pool as a separate legal entity, separate from that of the CPO. The CFTC may exempt a corporation from this requirement if: (i) the corporation represents in writing to the CFTC that each participant in its pool will be issued stock or other evidences of ownership in the corporation for all funds, securities or other property that the participant contributes for the purchase of an ownership interest in the pool; (ii) the corporation demonstrates to the satisfaction of the CFTC that it has established procedures adequate to assure compliance with the requirements in the paragraph set forth below; and (iii) the CFTC finds that the exemption is not contrary to the public interest and to the purposes of the provision from which the exemption is sought. All funds, securities or other property received by a CPO from an existing or prospective pool participant for the purchase of an interest or as an assessment (whether voluntary or involuntary) on an interest in a pool that it operates or that it intends to operate must be received in the pool s name. Finally, each pool s property may not be commingled with the property of any other person. CFTC Regulation f. Advertising. Fraudulent advertising by CPOs and their principals is prohibited, and restrictions are placed upon the use of testimonials and simulated or hypothetical trading results. CFTC Regulation 4.41; NFA Compliance Rule The NFA also requires members to maintain written supervisory procedures for the preparation and review of promotional materials, and imposes recordkeeping requirements as well. NFA Compliance Rule g. Supervision. CPOs should develop and follow written supervisory procedures for APs that are appropriate for their operations. These procedures should cover: 13 These amendments are effective September 23,

11 (1) hiring policies; (2) registration; (3) customer information; (4) account activity; (5) discretionary accounts; (6) promotional material; (7) customer complaints; and (8) ongoing training for firm personnel. This training should include monitoring of APs, which should include listening to sales solicitations and reviewing trading activity in customer and employee trading accounts, as well as providing additional training to APs regarding how to handle customers. CPOs must also oversee their branch offices, if any, including conducting on-site visits of these offices and maintaining a documented examination program. CFTC Reg and NFA Compliance Rule 2-9 and related Interpretive Notices. h. Swaps Firm. To the extent a CPO s pool trades swaps, the CPO must also register as a swaps firm and designate one of its principals who is also registered as an AP as a swaps AP. 3. Exclusions and Exemptions. a. Exemption for Persons Who Operate Pools Composed Solely of Qualified Eligible Persons. CFTC Regulation 4.7(b) provides an exemption from almost all the disclosure, reporting, and recordkeeping requirements otherwise applicable to registered CPOs. 14 However, this exemption is available only to a registered CPO, and only with respect to a pool composed solely of persons that the CPO reasonably believes are qualified eligible persons ( QEPs ). 15 Furthermore, the pool must be sold in an offering exempt from the registration requirements of the Securities Act pursuant to Section 4(2) of the Securities Act (for example, under Rule 506 of Regulation D) or Regulation S, or by a bank registered as a CPO with respect to a collective trust fund exempt from registration under Section 14 The DSIO indicated that a CPO that has relied on CFTC Regulation 4.13(a)(4) with respect to a fund prior to April 24, 2012, and wishes to transition to reliance on CFTC Regulation 4.7(b) for that fund, may claim all of the relief offered by subsections (1), (2) and (3) of CFTC Regulation 4.7(b) even though interests or shares of the fund were offered and sold, and commodity interest transactions were entered into, prior to the filing of the required notice under CFTC Regulation 4.7(d) because the interests that were offered and sold were done so in compliance with then-effective provisions of Part 4. See the FAQ (answer to question 1 under the heading Transitioning ). 15 CPOs of existing CFTC Regulation 4.13(a)(4) pools that become CFTC Regulation 4.7(b) pools as of January 1, 2013 will not be required to confirm that all participants in the existing CFTC Regulation 4.13(a)(4) pool continue to meet the QEP standard. However, the CPO must reasonably believe that any new participants meet the QEP standard at the time of investment to maintain regulatory relief under CFTC Regulation 4.7. Similar treatment and the ability to claim relief under CFTC Regulation 4.7 is accorded to CTAs that advised previously exempted pools. See the FAQ (answer to question 6 under the heading Transitioning ). 11

12 3(a)(2) of the Securities Act. These pools may not be marketed to the public. 16 i. Definition of Qualified Eligible Person. The definition of QEP is contained in CFTC Regulation 4.7(a)(2) and (a)(3). CFTC Regulation 4.7(a)(2) identifies persons who do not need to meet the Portfolio Requirement to be QEPs and CFTC Regulation 4.7(a)(3) identifies persons who must meet the Portfolio Requirement. Because both qualified purchasers and knowledgeable employees are defined as QEPs without having to meet the Portfolio Requirement, the eligibility requirements for Section 3(c)(7) of the Investment Company Act of 1940, as amended ( Investment Company Act ), and CFTC Regulation 4.7(b) funds are the same. 1.) Under CFTC Regulation 4.7(a)(1)(v), Portfolio Requirement means that a person must: a.) b.) c.) own securities (including pool participations) of issuers not affiliated with such person and other investments with an aggregate market value of at least $2 million; have had on deposit with a futures commission merchant ( FCM ), for its own account, at any time during the six months preceding the date it purchases the pool participation in the exempt pool, or opens an exempt account with a CTA, at least $200,000 in exchange-specified initial margin and option premiums, together with the required minimum security deposit for retail forex transactions for commodity interest transactions; or own a portfolio comprised of a combination of the funds or property specified in paragraphs a.) and b.) immediately above in which the sum of the funds or property includable under a.) above, expressed as a percentage of the minimum amount required, and 16 On July 10, 2013, the Securities and Exchange Commission (the SEC ) adopted final rules to eliminate the prohibition against general solicitation and general advertising in certain securities offerings under Rule 506 of Regulation D and Rule 144A under the Securities Act, as mandated by the Jumpstart Our Business Startups Act (the JOBS Act ). The final rules will take effect on September 23, Investment pools that trade commodity interests may be unable to engage in general solicitations despite the adoption of Rule 506(c) if their general partners, managers or advisers rely on CFTC Regulation 4.7(b), which, as stated above, requires interests in the commodity pool to be offered and sold without marketing to the public. We understand that CFTC staff intends to consider whether to modify these exemptions in response to the adoption of Rule 506(c), but not before the September 23 effective date. 12

13 the amount of futures margin and option premiums includable in b.) above, expressed as a percentage of the minimum amount required, equals at least 100%. (For example, $l million of securities (50% of $2 million under a.)) plus $100,000 of initial margin and option premiums (50% of $200,000 under b.)) would equal 100%.) 2.) QEPs who do not have to meet the Portfolio Requirement at the time of participation in an exempt pool or when an exempt account is opened include the following: a.) b.) c.) d.) e.) f.) g.) h.) i.) A registered FCM or its principals; A registered retail foreign exchange dealer or a principal thereof; A swap dealer registered pursuant to Section 4s(a)(1) of the CEA ( SD ), or a principal thereof; A registered broker or dealer or a principal thereof; 17 A registered CPO, registered and active for at least two years or who operates pools that have total assets in excess of $5 million, or a principal thereof; A registered CTA, registered and active for at least two years or who provides advice to commodity accounts that have total assets in excess of $5 million, or a principal thereof; An investment adviser registered under federal or state law, registered and active for at least two years or that provides advice to accounts with total assets in excess of $5 million on deposit with a brokerdealer; A qualified purchaser as defined in Section 2(a)(51)(A) of the Investment Company Act; A knowledgeable employee as defined in Rule 3c-5 under the Investment Company Act; 17 The inclusion of swap dealers became effective on November 5,

14 j.) k.) l.) m.) A trust, not formed for the specific purpose of either participating in the exempt pool or opening an exempt account, if the trustee or other person authorized to make investment decisions for the trust, and each settlor or other person who has contributed assets to the trust, are QEPs; An organization described in Section 501(c)(3) of the Internal Revenue Code of 1986, if the trustee or other person authorized to invest for the organization, and the person who established the organization, are QEPs; A Non-United States Person as defined in CFTC Regulation 4.7(a)(1)(iv); and An entity in which all participants or unit holders are QEPs. The CPO and CTA of the exempt pool or account are also exempt, as well as their affiliates and principals. Certain relatives of principals and other employees are also exempt. 3.) QEPs who must meet the Portfolio Requirement include: a.) b.) c.) d.) e.) f.) g.) Certain RICs and certain business development companies; Certain banks and savings and loan associations acting for their own account or for the account of a QEP; Certain insurance companies acting for their own account or for the account of a QEP; Certain governmental and private pension plans with total assets in excess of $5 million; Certain private business development companies; Section 501(c)(3) organizations with total assets in excess of $5 million; Certain corporations, Massachusetts or similar business trusts, or partnerships, other than pools, with total assets in excess of $5 million; 14

15 h.) i.) j.) k.) Natural persons with individual net worths, or joint net worths with their spouses, in excess of $1 million; Natural persons with individual incomes of $200,000 in each of the two most recent years, or joint net incomes with their spouses of $300,000 in each of the two most recent years, and reasonable expectations of reaching the same level in the current year; Certain pools, trusts, insurance company separate accounts, or bank collective trusts with total assets in excess of $5 million; and Certain U.S. and foreign governmental entities. If one of the above participants is a pooled vehicle (such as an investment company or collective investment fund), it also must not have been formed for the specific purpose of being a QEP. ii. Disclosure Document Requirements. The CPO may, but need not, deliver an offering memorandum to a QEP that describes, among other things, its use of commodity interests for the pool. However, if the CPO does deliver an offering memorandum to a QEP, it must (1) include all disclosures necessary to make the information contained therein, in the context furnished, not misleading, and (2) contain a prescribed legend on the cover page of the offering memorandum. If no offering memorandum is provided by the CPO, the legend must appear immediately above the signature line of the agreement that the participant must execute to become a pool participant. CFTC Regulation 4.7(b)(1)(i). CFTC Regulation 4.7(b) also provides an exemption from disclosing the past performance of exempt pools in Disclosure Documents for non-exempt pools unless such past performance is material to the non-exempt pool being offered. CFTC Regulation 4.7(b)(1)(ii). A CPO that is relying upon this exemption must state in a footnote to the performance disclosure in a Disclosure Document for a non-exempt pool that the operator is operating or has operated exempt pools whose performance is not included in this Disclosure Document. 15

16 iii. Periodic Reporting Requirements. CPOs of exempt pools generally are exempt from most of the other periodic reporting requirements applicable to CPOs. However, certain quarterly and annual reports must be furnished to pool participants. Annual reports also must be filed electronically with NFA. CFTC Regulation 4.7(b)(2) and (3). CFTC Regulation 4.22 gives CPOs the opportunity to obtain a filing extension for annual reports in certain circumstances, such as, in the fund-of-funds context, when financial information from underlying funds is not timely. See CFTC Regulation 4.22(f). iv. Recordkeeping Requirements. CFTC Regulation 4.7(b)(4) was amended by the CFTC in the Harmonization Release to delete the requirement that the CPO keep at the main business location of the CPO the prescribed annual and quarterly reports and all books and records prepared in connection with its activities as a CPO of exempt pools. All CPOs are now allowed to use certain third-party service providers 18 to manage their recordkeeping obligations, provided that, if the CPO does so, the CPO notifies the CFTC through the NFA as required under amended CFTC Regulation 4.23(c). For existing funds, this notice was due by September 23, These books and records must demonstrate the qualifications of the CPO s QEPs (i.e., how the CPO reasonably believes that its participants are QEPs) and substantiate any performance representations made by the CPO to participants. The books and records must be available for inspection within 48 hours (72 hours if held outside the United States) to representatives of the CFTC, NFA and the U.S. Department of Justice. If a CPO would like to maintain some or all of its required records solely in electronic format, before doing so, it must enter into an arrangement with at least one third party Technical Consultant. The purpose of requiring the Technical Consultant is to provide the CFTC or U.S. Department of Justice ( DOJ ) with access to records in a readable format. If the CPO uses an electronic storage system, it (or the storage system vendor or another third party with appropriate expertise) must provide a representation to the CFTC that the storage system meets the requirements of CFTC Regulation 1.31(b)(1)(ii). Christopher Cummings, an attorney in 18 Permissible recordkeepers include the pool s administrator, distributor or custodian, or a bank or registered broker or dealer acting in a similar capacity with respect to the pool. The CFTC is considering adding additional permissible recordkeepers to this list. 16

17 DSIO, is the individual who accepts undertakings from Technical Consultants regarding electronic records. v. Notice. The notice of a claim for exemption under CFTC Regulation 4.7(b) must comply with the requirements listed under CFTC Regulation 4.7(d)(1) and must be filed electronically with NFA before the date the pool first enters into a commodity interest transaction if the relief requested is limited to reporting and recordkeeping requirements, and received prior to any offer or sale of any participation in the pool if the relief requested also includes the disclosure requirements. If pool participations were sold in full compliance with CFTC regulations, the CPO may convert to operating the pool in accordance with CFTC Regulation 4.7, provided that is consistent with the rights of pool participants. A majority of participants unaffiliated with the CPO must approve of the change and those who object must be treated like participants in non-exempt pools or be given the chance to redeem within three months of the filing of a notice under CFTC Regulation If any CPO that has filed a notice under CFTC Regulation 4.7 ceases to be eligible for the relief claimed, the CPO is required to file a notice promptly with NFA advising it of such change. CFTC Regulation 4.7(d)(3). 4. Exemption for CPOs Whose Use of Commodity Interests is Limited. The exemption contained in CFTC Regulation 4.12(b) is available only for a person who is registered as a CPO or who has applied for CPO registration. Further, it exempts the CPO from only some of the disclosure (primarily, disclosure of past performance of the pool and its principals, and the pool s CTA and its principals), reporting, and recordkeeping requirements generally applicable to CPOs. The CFTC Regulation 4.12(b) exemption often is used by managers of privately-placed limited partnerships or limited liability companies that invest in commodity interests, in addition to securities. 19 The DSIO has not precisely addressed the issue of whether a CPO transitioning from CFTC Regulation 4.13(a)(4) status into CFTC Regulation 4.7(b) status would be required to provide participants who object to this change with disclosure and reporting in accordance with what is required for full compliance under the Part 4 regulations or a three-month window in which to redeem their units of participation in the pool. Because transitioning from operating under CFTC Regulation 4.13(a)(4) to operating under CFTC Regulation 4.7 results in greater regulatory coverage for participants, full Part 4 reporting and disclosure or the right to redeem should not be necessary or required, but a notice of the change of exemption should be provided to investors. 17

18 In order to meet the exemption requirements of CFTC Regulation 4.12(b), the pool must: a. Be offered and sold in compliance with the registration requirements of the Securities Act, or an exemption from such registration requirements; 20 b. Be engaged generally and routinely in the buying and selling of securities and securities-derived instruments; c. Trade commodity interests in a manner solely incidental to its securities trading activities; and d. Not enter into commodity interest transactions for which the aggregate initial margin and premiums, and required minimum security deposit for retail forex transactions, exceed 10% of the fair market value of the pool s assets, after taking into account unrealized profits and unrealized losses on such contracts. In the case of an option that is in-the-money at the time of purchase, the in-the-money amount (as defined in CFTC Regulation (x)) may be excluded in computing such 10%. Each existing and prospective pool participant also must be informed in writing of the limitations described in paragraphs c. and d. immediately above before the pool commences trading commodity interests. To use this exemption, the CPO must file a notice with NFA electronically before the pool enters into a commodity interest transaction. CFTC Regulation 4.12(b)(3) and (4). Certain disclosures regarding the utilization of the exemption must also be made in the pool s offering memorandum and annual reports. CFTC Regulation 4.12(b)(3). 5. Exclusion for Certain Otherwise Regulated Persons. CFTC Regulation 4.5 excludes from the definition of CPO persons that operate pools that are regulated by some other regulatory authority. As this is an exclusion, all the CFTC s CPO requirements are not applicable. CFTC Regulation 4.6(a)(2) excludes from the definition of CTA any person who is excluded from the definition of CPO under CFTC Regulation 4.5. a. Persons Excluded. The following persons, and principals and employees thereof, are excluded from the definition of CPO with respect to the operation of the respective qualifying entities. However, they must comply with other requirements of CFTC Regulation 4.5. A qualifying entity is: i. a RIC; See note 16 regarding the JOBS Act. 18

19 ii. iii. iv. an insurance company subject to state regulation with respect to the operation of a separate account; a bank, trust company or any financial depository institution subject to regulation by any state or the United States with respect to the assets of a trust, custodial or other separate unit of investment for which it is acting as a fiduciary and for which it is vested with investment discretion; or a trustee of, named fiduciary of, or an employer maintaining, a pension plan that is subject to Title I of the Employee Retirement Income Security Act of 1974, as amended ( ERISA ). 22 In the Amendment Release, the CFTC made clear that a wholly-owned subsidiary of a RIC, generally referred to as a controlled foreign corporation or CFC (used by many RICs to invest directly in commodity interests to obtain favorable tax treatment), may not rely upon the exclusion of CFTC Regulation 4.5 and thus must have a registered CPO operating it, unless the operator may take advantage of an exemption from registration. The RIC-CFC relationship may be treated like a master-feeder structure to avoid the need for the operators of the CFC to furnish a Disclosure Document or other reports to the RIC. Further, DSIO issued Staff Letter on September 5, 2013, stating that it will not recommend that the CFTC take enforcement action against operators of RICs for failure to provide a separate report for their CFCs to the NFA pursuant to CFTC Regulation 4.27(c), and a separate annual report for their CFCs to the NFA pursuant to CFTC Regulation 4.22(c), provided that such operators consolidate the reporting for the CFCs with those of the RIC. b. Other Excluded Pools. The CFTC also has excluded certain other employee benefit plans from the definition of a commodity pool, thereby excluding the operators of these plans from the definition of CPO under CFTC Regulation 4.5. These employee benefit plans are: 21 In the Amendment Release, effective April 24, 2012, the CFTC amended CFTC Regulation 4.5 as it applies to RICs. Under the amendments, RICs wishing to continue to claim the CFTC Regulation 4.5 exclusion from CPO status are required to limit their use of commodity interests, and comply with certain marketing restrictions. Advisers to RICs that were relying on the CFTC Regulation 4.5 exclusion as of the effective date of the amendment, April 24, 2012, had until December 31, 2012 to confirm that they can rely on amended CFTC Regulation 4.5 or register as CPOs, as appropriate. Compliance with the CFTC s recordkeeping, reporting and disclosure requirements pursuant to Part 4 of the CFTC s regulations was postponed until 60 days after the effectiveness of the Harmonization Release. Amendment Release, 77 Fed. Reg In CFTC No-Action Letter (Dec. 21, 2012), the DSIO extended the relief in Regulation 4.5 to an investment adviser sponsor of a group trust formed and operated exclusively to invest the assets of certain defined benefit plans. 19

20 i. noncontributory plans, whether defined benefit or defined contribution, covered by Title I of ERISA; ii. iii. iv. contributory defined benefit plans covered under Title IV of ERISA if, with respect to any such plan to which an employee may voluntarily contribute, no portion of an employee s contribution is committed as margin or premiums for futures contracts or commodity options; governmental plans as defined in Section 3(32) of Title I of ERISA; employee welfare benefit plans that are subject to the fiduciary responsibility provisions of ERISA; and v. a plan defined as a church plan in Title I, Section 3(33) of ERISA and with respect to which no election has been made under 26 U.S.C. 410(d) (e.g., participation, vesting and funding provisions of ERISA). c. Other Requirements. To take advantage of the exclusion provided by CFTC Regulation 4.5, the persons listed in the first group above must make certain representations to NFA. The representations must be contained in a notice filed electronically, and the notice, which is effective upon filing, must be filed before the person may claim the exclusion offered by CFTC Regulation 4.5 and operate the qualifying entity. This notice must be reaffirmed annually within 60 days of calendar year end. i. Disclosure to Participants. The qualifying entity must disclose in writing to each participant, whether existing or prospective, that the qualifying entity is operated by a person who has claimed an exclusion from the definition of CPO, and who therefore is not subject to registration or regulation as a CPO. This disclosure must be made in accordance with the requirements of any other federal or state regulatory authority to which the qualifying entity is subject. ii. Special Calls. The qualifying entity must agree to submit to special calls as the CFTC may make to require the qualifying entity to demonstrate that it is complying with CFTC Regulation

21 If any of the information or representations in the notice becomes inaccurate or incomplete, a supplemental notice must be filed with NFA electronically within 15 business days. The filing of a notice of eligibility or the application of non-pool status under CFTC Regulation 4.5 does not affect the ability of a person to qualify for an exemption from registration as a CPO under CFTC Regulation 4.13 in connection with the operation of another trading vehicle that is not covered under CFTC Regulation CFTC Regulation 4.13: Exemptions to CPO Registration for Pools. a. CFTC Regulation 4.13(a)(3). CFTC Regulation 4.13(a)(3) exempts a CPO from registration if, among other conditions: (1) interests in the pool are exempt from registration under the Securities Act and such interests are offered and sold without marketing to the public in the United States; 23 (2) it restricts participation in the pool to accredited investors, as defined in Rule 501 of Regulation D under the Securities Act, certain family trusts formed by accredited investors, knowledgeable employees as defined in Rule 3c-5 under the Investment Company Act, persons who are QEPs under CFTC Regulation 4.7(a)(2)(viii)(A) (this category includes QEPs that have a relationship with a CPO), or persons eligible to participate in a pool for which the pool operator may claim exemption from registration under rescinded CFTC Regulation 4.13(a)(4) discussed below; 24 (3) it limits the commodity interest positions (whether or not entered into for bona fide hedging purposes) in each of its pools such that either (i) the aggregate initial margin, premiums and required minimum security deposit for retail forex transactions required to establish such positions will be limited to 5% of the liquidation value of the pool s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into; or (ii) the aggregate net notional value (as described below) of such positions, determined at the time the most recent position was established, does not exceed 100% of the liquidation value of the pool s portfolio, after taking into account unrealized profits and unrealized losses on any positions it has entered into; and (4) it does not market participation in the pool as or in a vehicle for trading in the commodity futures or commodity options markets. CFTC Regulation 4.13(a)(3) describes how notional value is calculated for these purposes. For futures contract positions, notional value is calculated by multiplying the number of contracts by the size of the See note 16 regarding the JOBS Act. See the FAQ (answer to question 2 under the heading Regulation 4.13 ). 21