CFTC Harmonization Rules - PDF Free Download

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Introduction The CFTC adopted rules to harmonize compliance obligations for certain registered investment companies New reporting and disclosure requirements for registered investment companies that fall within the definition of commodity pools An adviser to these investment companies must register as a commodity pool operator (CPO) New rules ended months of handwringing by investment companies and their advisers because without harmonization, funds would be subject to overlapping and conflicting reporting and disclosure rules. 3

Background February 2012 CFTC modified Rule 4.5 exclusions from the definition of CPO Rule 4.5 modified exclusion from CPO definition for registered investment companies (RICs) Certain investment advisers of RICs must register with CFTC as CPOs At the same time, the CFTC proposed rules to harmonize to the fullest extent practicable the disclosure, reporting and recordkeeping rules that would apply to RICs that are also commodity pools CFTC received many comments regarding changes to Rule 4.5 Commenters noted that RICs would be subject to duplicative, inconsistent and possibly conflicting disclosure and reporting requirements if they must comply with both SEC and CFTC rules 4

Background (con td) August 2013 CFTC adopts final harmonization rules CFTC adopts substituted compliance regime for CPOs of RICs Premised largely on funds adherence to SEC compliance requirements CFTC will accept compliance by these funds with SEC s disclosure, reporting and recordkeeping regime CFTC also amended some disclosure, reporting and recordkeeping rules that apply to all CPOs August 2013 SEC Division of Investment Management publishes guidance for RICs that use derivatives Guidance coincides with harmonization rules and provides SEC perspective 5

Commodity Pool Operator As amended by Dodd-Frank, the CEA now defines the term commodity pool operator to include any person: (i) 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 (I) commodity for future delivery, security futures product, or swap; (II) agreement, contract, or transaction described in section 2(c)(2)(C)(1) or section 2(c)(2)(D)(i) of the CEA of the CEA; (III) commodity option authorized under section 6c of the CEA; or (IV) leverage transaction authorized under section 23 of the CEA; or (ii) who is registered with the CFTC as a commodity pool operator 6

Commodity Pool Operator (cont d) In addition, the CFTC has the authority to include within, or exclude from, the CPO definition any person if such inclusion or exclusion will effectuate the purposes of the CEA A CPO: Is de facto a financial entity that cannot rely on the end-user exemption The CPO must register itself, and register its principals and associated persons, as members of the NFA Requires filing of a Form 7-R for the entity, and an 8-R for each AP/principal A principal will be understood to include a director, officer, or anyone with decision-making authority A holder of 10% or more of the equity of the entity also is considered a principal An AP must take a Series 3 exam, required ethics training, and subject itself to fingerprinting and other registration obligations Is subject to ongoing compliance obligations 7

Commodity Pool Operator (cont d) CPO is subject to oversight and examinations by the NFA CPO must comply with various initial and ongoing reporting, recordkeeping and other requirements, including: The requirement to appoint a CCO The obligation to file with, and have approved by, the NFA a disclosure document, and comply with regulations relating to information disclosures A requirement to maintain compliance policies and procedures to provide for appropriate custody of client assets; secure privacy of client information; comply with anti-money laundering requirements; prevent manipulative or disruptive trading practices, ensure business continuity, maintain accurate records, etc. File certain annual and other reports, such as Forms CPO-PQR and CTA-PR 8

Rule 4.5 Exclusion Rule 4.5 excludes from the definition of a CPO qualifying entities that operate pools regulated by some other regulatory authority Qualifying entities include Registered investment companies (that comply with restrictions) Insurance companies with respect to separate account Bank, trust company or financial depository institution with respect to trust or custodial assets while acting in fiduciary capacity Trustee or named fiduciary of, or employer maintaining an ERISA pension plan February 9, 2012 CFTC amended Rule 4.5 to sharply limit the ability of advisers to RICs that use derivatives to rely on the exclusion New rule excludes only CPOs of RICs that commit no more than a de minimis portion of their assets to trading in commodity interests that do not fall within the definition of bona fide hedging and who do not market themselves as a commodity pool or commodity interest Adviser of a RIC that exceeds de minimis level is no longer excluded from the definition of a CPO and must register with CFTC 9

Rule 4.5 Exclusion (cont d) Reinstatement of 5% threshold Eliminated in 2003 Requires advisers to registered funds that hold certain commodity interests whose aggregate initial margin and premiums that exceed 5% of the liquidation value of the fund s portfolio to register as CPO Distinguish between derivatives for risk management and bona fide hedging Count derivatives trades used for managing risk toward 5% limit, but exclude bona fide hedging transactions OK to exclude options that are in-the-money options at time of purchase Alternative net notional test Fund s aggregate net notional value of the fund s commodity interest positions may not exceed 100% of the liquidation value of the fund s portfolio (taking into account unrealized profits) Funds can satisfy either test Notional value defined for futures and swap positions 10

Rule 4.5 Exclusion (cont d) Netting Funds may net futures contracts with the same underlying commodity across designated contract markets and foreign boards of trade Swaps cleared on the same designated clearing organization when appropriate Holding out To rely on the exemption, fund must not hold itself out as a vehicle for trading commodity interests Annual notice Funds relying on Rule 4.5 must file notice of exclusion and annual affirm the notice Must withdraw exemption if activities no longer would require registration Who must register? Advisers to funds that qualify as CPOs but do not otherwise qualify for an exclusion or another exemption from registration must register with CFTC 11

Rule 4.5 Exclusion (cont d) Why? CFTC expressed concern that certain registered funds were offering interests in de facto commodity pools while claiming exclusion from the definition from the definition of CPO pursuant to Rule 4.5 CFTC concerned that funds are using managed futures strategies without proper oversight under the guise of being an investment company CFTC aware of increased trading activity in the derivatives area by such entities that may not be appropriately addressed in the existing regulatory protections, including risk management and recordkeeping and reporting requirements Effect of amended rules Increased compliance costs of investment companies and advisers that are required to register with the CFTC and are subject to CFTC regulation Some funds may find alternatives to using covered commodity interests Dissent One Commissioner dissented, saying that cost-benefit analysis would not survive judicial scrutiny (she was not correct) 12

Rule 4.5 Fallout April 17, 2012 ICI and Chamber of Commerce sue CFTC Argue that amended Rule 4.5 imposes unnecessary, overlapping and burdensome regulation on funds, advisers and shareholders Claimed that Rule 4.5 amendments are arbitrary and capricious and that CFTC violated APA December 12, 2012 District Court upholds CFTC s Rule 4.5 amendments Nothing arbitrary and capricious about the CFTC s decision to amend rules Plaintiffs have thrown everything in the proverbial kitchen sink at the CFTC in efforts to stop the rules December 27, 2012 ICI and Chamber file Notice of Appeal January 3, 2013 ICI and Chamber file Emergency Motion for expedited consideration of appeal June 25, 2013 Court of Appeals rejects ICI/Chamber challenge 13

CFTC Harmonization Rules The challenge: harmonize duplicative, inconsistent and conflicting disclosure and reporting requirements How do investment advisers to registered funds that do not satisfy Rule 4.5 conditions comply with these inconsistent requirements? Timing and delivery of disclosure documents Signed acknowledgement requirement for receipt of disclosure documents Update cycle Timing of financial reporting Record keeping requirements Required disclosure of fees Required disclosure by CFTC of past performance Mandatory certification language required by CFTC SEC-permitted use of summary prospectus 14

Harmonization Rules Harmonization rules are grounded in the concept of substituted compliance SEC s disclosure, reporting and recordkeeping rules are designed to achieve goals similar to those of the CFTC CFTC deems CPOs of RICs that comply with SEC s rules to comply with Part 4 of CFTC s regulations A CPO of a RIC that fails to comply with SEC rules would violate its obligations under CFTC rules CFTC significantly broadened its original approach 15

Harmonization Rules (cont d) Key changes from original proposal CFTC deems CPOs of RICs to be in compliance with Rules 4.21, 4.22(a) and (b), 4.24, 4.25 and 4.26 if the satisfy all applicable SEC rules and certain other conditions All CPOs will be permitted to use third-party service providers to maintain their books and records The CFTC rescinded the signed acknowledgement requirement that applied to all CPOs. Choice of compliance A CPO of a RIC may Comply with Part 4 requirements to all CPOs, or Elect to comply through substituted compliance, subject to specified conditions in Rule 4.12(c) 16

Harmonization Rules (cont d) Substitute compliance conditions The CPO of a RIC must file with the National Futures Association (NFA) a notice that it will use substituted compliance The CPO of a RIC with less than three years operating history must disclose the performance of all accounts and pools managed by the CPO that have investment objectives, policies and strategies substantially similar to those of the offered pool The CPO of a RIC must file with the NFA financial statements that it prepares to meet its SEC obligations If the CPO of a RIC uses or intends to use third-party service providers for recordkeeping purposes, it must file a notice with the NFA 17

Harmonization Rules (cont d) Disclosure requirements Disclosure documents Old Rule 4.26(a)(2): a CPO may may not use disclosure documents dated more than 9 months prior to the date of its use New rule: All CPOs may use disclosure documents up to 12 months from the date of the document RICs can comply with applicable SEC timelines Generally, RICs must amend prospectus within 4 months of fiscal year end Correction to incorrect disclosure documents Rule 4.26(c): if the CPO learns of incompleteness or material inaccuracy, it must correct the defect and distribute the correction within 21 days RICS can comply with applicable SEC rules to correct errors 18

Harmonization Rules (cont d) Disclosure requirements Delivery requirements Rule 4.21 requires a CPO to deliver a disclosure document and obtain a signed acknowledgement before accepting or receiving funds RICs may rely on SEC delivery rules, provided that the prospectus is available on a website CFTC treats a series fund as a single legal entity SEC rules allow multiple series to be included in registration statement of a single registrant, but allows reporting and disclosure to be accomplished on a series by series basis CFTC deferred to SEC s approach for purposes of compliance with delivery requirements CFTC rescinded the signed acknowledgement requirement of Rule 4.21(b) for all registered CPOs 19

Harmonization Rules (cont d) Disclosure requirements Prior NFA review of disclosure documents Rule 4.26 requires NFA to review disclosure documents 21 days before use CPOs to RICs must file disclosure documents with NFA, but they will not be subject to prior NFA approval By filing a notice of intent to rely on substitute compliance, NFA can identify which CPOs are claiming relief and are not required to comply with its rules Risk statements and legends Rule 4.24(a) - requires extensive cautionary statement RICs can use SEC Rule 481 cautionary statement, modified to include CFTC Standard risk disclosure Rule 424(b) requires specific standard risk disclosures RICs can use risk disclosures that comply with SEC standards Break even disclosure Rule 4.24(d)(5) requires break-even disclosure RICs can use SEC standard SEC fee disclosures required by Form N-1A 20

Harmonization Rules (cont d) Disclosure requirements Past performance disclosure Rule 4.24(n) requires CPOs to disclose certain past performance information for each pool that it operates RICs with less than three years of history may comply by disclosing performance of other pools managed by the CPO that have substantially similar strategies Fee disclosure Rule 4.24(i) requires CPOs to disclose certain fees, including brokerage commissions and other fees CFTC requires separate disclosure of brokerage fees, while SEC rules permit brokerage fees to be included in cost of securities RICs may comply with SEC requirements for fee disclosures Controlled foreign corporations (CFCs) CFTC recognized that some RICs implement futures strategies through CFCs CFTC rules may require operator of CFC to register as a CPO CFTC will not require operator of CFC to register as a CPO, provided the RIC fully discloses material information about CFC s activities 21

Harmonization Rules (cont d) Financial reporting Periodic financial statements Rule 4.22 requires CPOs to send monthly account statements to all pool participants (quarterly if pool has assets of less than $500,000) RICs may comply with CFTC rules by sending annual and semi-annual reports, as required by SEC Books and records Location of records Rules 4.23 and 4.7(b)(4) require pools to maintain assets at CPO s office Rule 4.23 allows ETFs to maintain records with third parties New rules apply the ETF standard to RICs All CPOs may now maintain records with a third party, provided they file a statement with the CFTC Application to other CPOs CFTC seeks comments on whether to extend relief provided to CPOs of RICs to other CPOs 22

Compliance Dates Compliance dates August 22, 2013 (date of publication in the Federal Register) All harmonization rules other than the conditions contained Rule 4.12(c)(3)(i) Compliance dates linked to filing registration statement with the SEC Rule 4.12(c)(3)(i) The rule requires CPOs of a pool with less than a 3-year operating history to disclose its performance of all accounts and pools that are managed by the same CPO and have investment objectives, policies and strategies substantially similar to that of the RIC Open-end funds CPOs must comply beginning with a RIC files with the SEC an initial registration statement, or when an existing RIC files its first post-effective amendment that is an annual update to an existing registration statement Closed-end funds CPOs must comply with the RIC is required to update its registration statement 23

Compliance Dates (cont d) Compliance dates October 21, 2013 (60 days after the effective date of harmonization rulemaking) Form CPO-PQR August 22, 2013 (date of publication in Federal Register) Rule 4.21 (eliminates signed acknowledgement for all registered CPOs) September 21, 2013 (30 days after publication in Federal Register) Rule 4.7(b)(4) books and records Rule 4.23 books and records Rule 4.26 - periodic statements Rule 4.36 disclosure documents of commodity trading advisers (CTAs) 24

SEC Staff Guidance Investment Management Division Guidance Update No. 2013-05 Published to coincide with publication of CFTC s harmonization rules Staff disclosure and compliance guidance for funds that invest in commodity interests Funds that use or intend to use derivatives should assess the accuracy and completeness of their disclosure, including whether the disclosure is presented in an understandable manner using plain English tailor principal investment strategies disclosure related to derivatives specifically to how a fund expects to be managed and should address those strategies that the fund expects to be the most important means of achieving its investment objective and that it anticipates will have a significant effect on its performance consider the degree of economic exposure the derivatives create in addition to the amount invested in the strategy describe the purpose that the derivatives are intended to serve assess, on ongoing basis, completeness and accuracy of derivatives related disclosure in light of actual operations 25

SEC Staff Guidance (cont d) Risk disclosures should be tailored to the types of derivatives that the fund uses, the extent of their use, and their purpose provide investors with a complete risk profile of a fund s investments, taken as a whole, rather than a list of risks of various derivative strategies reflect anticipated derivatives usage Relate to risks that are material to investors (e.g., volatility, liquidity, counterparty creditworthiness) Funds should assess, on ongoing basis, completeness and accuracy of derivatives related disclosure in light of actual operations Performance presentations The staff reminded funds that performance comparisons must not be materially misleading This is a reference to the CFTC s new requirement for funds with less than three years of operating experience to disclose performance of funds or accounts with similar strategies 26

SEC Staff Guidance (cont d) Legend requirement The staff will not object if funds modify the Rule 481 legend to refer to the CFTC Compliance and risk management The staff reminded advisers that they are primarily responsible for day-to-day compliance and risk management the fund s board generally oversees the adviser s risk management activities as part of the board s oversight of the adviser s management of the fund Adviser and fund compliance policies should address fund use of derivatives Including portfolio management and disclosure of investment objectives, policies, strategies and risks SAI must disclose the extent of the board s role in risk oversight, and how the board administers its oversight function 27