Vedder Thinking | Articles CFTC, NFA and CME Regulatory Updates
CFTC Relief from Provisions of Rules 4.7(b) and 4.13(a)(3) to Harmonize with JOBS Act Amendments to Rule 506(c) and Rule 144A
On September 9, 2014, the Division of Swap Dealer and Intermediary Oversight (DSIO) of the Commodity Futures Trading Commission (CFTC) issued CFTC Letter No. 14-116 (Letter 14-116). Letter 14-116 grants exemptive relief from specific provisions of CFTC Rules 4.7(b) and 4.13(a)(3) to commodity pool operators (CPOs) to be consistent with the Jumpstart Our Business Startups (JOBS) Act's amendments to the Securities and Exchange Commission (SEC) Regulation D adding Rule 506(c) and revising Rule 144A under the Securities Act of 1933, as amended (Securities Act). Rule 506(c), as amended pursuant to the JOBS Act, permits issuers to engage in general solicitation and general advertising as long as certain conditions are satisfied. Prior to the issuance of Letter 14-116, CFTC rules generally prevented certain private funds from relying on amended Rule 506.
Letter 14-116 provides relief from the CFTC Rule 4.7(b) requirement that an offering be exempt pursuant to section 4(a)(2) of the Securities Act and be offered solely to qualified eligible persons (QEPs). Letter 14-116 also provides relief from the requirement of CFTC Rule 4.13(a)(3)(i) that securities be "offered and sold without marketing to the public."
To be eligible for the relief, the following requirements must be satisfied:
- the CPO must be relying on the Rule 506(c) exemption or be a CPO using a Rule 144A reseller; and
- the CPO must be relying on either CFTC Rule 4.7 or 4.13(a)(3).
The relief is not self-executing. A notice of claim must be filed in the form described below:
- state the name, business address and main business telephone number of the CPO claiming the relief;
- state the name of the pool(s) for which the claim is being filed;
- state whether the CPO claiming relief is a Rule 506(c) issuer or is using one or more Rule 144A resellers;
- specify whether the CPO intends to rely on the exemptive relief pursuant to Rule 4.7(b) or 4.13(a)(3), with respect to the listed pool(s);
- if relying on Rule 4.7(b), represent that the CPO meets the conditions of the exemption, other than that provision's requirements that the offering be exempt pursuant to section 4(a)(2) of the Securities Act and be offered solely to QEPs, such that the CPO meets the remaining conditions and is still required to sell the participations of its pool(s) to QEPs;
- if relying on Rule 4.13(a)(3), represent that the CPO meets the conditions of the exemption, other than that provision's prohibition against marketing to the public;
- be signed by the CPO, which may be accomplished by attaching a portable document format (PDF) file with a signature of the CPO; and
- be filed with the DSIO via e-mail using the e-mail address of email@example.com with the subject line "JOBS Act Marketing Relief."
Once obtained, the relief will not expire absent any final CFTC action in consideration of the JOBS Act and the SEC's regulatory amendments.
A link to Letter 14-116 can be found here.
CPO Reporting Relief for a Parent Pool and Its Trading Subsidiary
On September 8, 2014, the DSIO issued CFTC Letter No. 14-112 (Letter 14-112), which grants no-action relief to permit certain commodity pools and their wholly owned subsidiaries to consolidate the annual report financial statements and Form CPO-PQR data. In particular, the DSIO will not recommend that the CFTC take an enforcement action against a CPO of a parent commodity pool (Parent Pool) that uses a wholly owned subsidiary to trade in commodity interests (Trading Subsidiary) for failure to file with the National Futures Association (NFA) a separate annual report for such Trading Subsidiary, pursuant to CFTC Rule 4.7(b) or 4.22(c), or for failure to file a separate Form CPO-PQR with NFA for such Trading Subsidiary, pursuant to CFTC Rule 4.27(c). Letter 14-112 does not apply to CPOs of registered investment companies.1
To be eligible for the consolidated annual report relief, the following requirements must be satisfied:
- the Parent Pool cannot be registered as an investment company under the Investment Company Act of 1940 (1940 Act);
- the CPO of the Parent Pool must also be the CPO of the Trading Subsidiary;
- exposure to the Trading Subsidiary by participants in the Parent Pool must be shared pro rata; and
- the CPO must prepare and file with NFA an annual report for the Parent Pool that contains consolidated financial statements for the Parent Pool that includes the holdings, gains and losses, and other financial statement amounts attributable to the Trading Subsidiary.2
To be eligible for the consolidated Form CPO-PQR relief, the above requirements 1-3 must be satisfied, and the CPO must provide a consolidated report to NFA for the Parent Pool that includes the data for the Trading Subsidiary, pursuant to CFTC Rule 4.27(c).
The relief is not self-executing. A notice of claim must be filed in the form described below:
- state the name, main business address and main business telephone number of the CPO claiming the relief;
- state the capacity (i.e., CPO) and the name of each Trading Subsidiary for which the claim is being filed and the name of the Parent Pool matched with each Trading Subsidiary;
- be signed by the CPO, which may be accomplished by attaching a portable document format (PDF) file with the signature of the CPO; and
- be filed with the DSIO via e-mail using the e-mail address of firstname.lastname@example.org with the subject line "Trading Subsidiary Letter 14-112."
Once obtained, the relief will not expire absent a future rulemaking or other CFTC action relating to the subject matter of the relief.
A link to Letter 14-112 can be found here.
CFTC Relief to Use Additional Third-Party Recordkeepers
On September 8, 2014, the DSIO issued CFTC Letter No. 14-114 (Letter 14-114), which grants exemptive relief from the main office requirement of CFTC Rules 4.7(b)(4) and 4.23 to allow CPOs to use any third-party recordkeeper. Prior to the relief set forth in Letter 14-114, CPOs were only allowed to use the specific recordkeepers enumerated in "Harmonization of Compliance Obligations for Registered Investment Companies Required to Register as Commodity Pool Operators."
To be eligible for such relief, the following requirements must be satisfied:
- the CPO's timely access to such records must be maintained, such that the CPO will satisfy the obligations of the applicable CFTC rules, particularly with respect to providing such records for inspection; and
- the CPO must timely and completely file the statements required pursuant to CFTC Rule 4.7(b)(5) or 4.23(c), as applicable.
A link to Letter 14-114 can be found here.
Form CPO-PQR Relief for CPOs to Certain Exempt or Excluded Pools
On September 8, 2014, the DSIO issued CFTC Letter No. 14-115 (Letter 14-115), which grants exemptive relief from the requirement to file a Form CPO-PQR under CFTC Rule 4.27(c), where the CPO is registered but only operates pools pursuant to a claim of exemption from registration under CFTC Rule 4.13(a)(3) or for which the CPO maintains an exclusion from the definition of CPO under CFTC Rule 4.5. The relief is being granted since these CPOs only operate pools for which they do not have a reporting requirement. Reporting on a Form CPO-PQR would provide limited additional information regarding such CPOs beyond what is already available to the CFTC as part of the registration process and the CPO's ongoing obligations as a registrant.
A link to Letter 14-115 can be found here.
New CME Rule 575 on Disruptive Trading Practices
Effective September 15, 2014, the Chicago Mercantile Exchange, Chicago Board of Trade, New York Mercantile Exchange and Commodity Exchange, Inc. (collectively, the CME) adopted a new Rule 575 to prohibit:
- "spoofing" (i.e., submitting or cancelling bids or offers to create a misleading appearance of market depth or artificial price movements);
- "quote stuffing" (i.e., submitting or cancelling bids or offers to overload the quotation system of a registered entity or delay another person's execution of transactions during the closing period); and
- the disorderly execution of transactions during the closing period.
The text of the new Rule 575 reads as follows:
All orders must be entered for the purpose of executing bona fide transactions. Additionally, all non-actionable messages must be entered in good faith for legitimate purposes.
A. No [P]erson shall enter or cause to be entered an order with the intent, at the time of order entry, to cancel the order before execution or to modify the order to avoid execution;
B. No Person shall enter or cause to be entered an actionable or non-actionable message or messages with intent to mislead other market participants;
C. No Person shall enter or cause to be entered an actionable or non-actionable message or messages with intent to overload, delay, or disrupt the systems of the Exchange or other market participants; and
D. No [P]erson shall enter or cause to be entered an actionable or non-actionable message with intent to disrupt, or with reckless disregard for the adverse impact on, the orderly conduct of trading or the fair execution of transactions.
To the extent applicable, the provisions of this Rule apply to open outcry trading as well as electronic trading activity. Further, the provisions of this Rule apply to all market states, including the pre-opening period, the closing period and all trading sessions (emphasis added).
The CME also prepared CME Group RA1405-5 (the Advisory Notice) to provide additional guidance in interpreting the new rule. The Advisory Notice provides a non-exhaustive list of examples considered to be disruptive and in violation of Rule 575. As to the standard of proof, under A16 of the Advisory Notice, it states:
Proof of intent is not limited to instances in which a market participant admits its state of mind. Where the conduct was such that it more likely than not was intended to produce a prohibited disruptive consequence without justification, intent may be found. Claims of ignorance, or lack of knowledge, are not acceptable defenses to intentional or reckless conduct. Recklessness has been commonly defined as conduct that “departs so far from the standards of ordinary care that it is very difficult to believe the actor was not aware of what he or she was doing. See Drexel Burnham Lambert, Inc. v. CFTC, 850 F.2d 742, 748 (D.C. Cir. 1988).
Based on the Advisory Notice, the "intent" required under parts A-C of Rule 575 (as provided above) is likely a lower standard than market participants anticipated. Further, claims of ignorance, or lack of knowledge, would not be acceptable defenses to intentional (or reckless) conduct. For the catchall under part D, a plain recklessness standard applies. Such low thresholds for the CME to show intent and/or recklessness could have a particularly sharp impact on high frequency trading and algorithmic trading firms. Such firms should carefully consider the impact on the new rule on their trading.
Potential CPO and CTA Registration Relief for Registered Investment Companies
Section 361 of the proposed 2014 CFTC Reauthorization Act (the Proposed Act) could dramatically affect many registered investment companies (RICs) and their advisers. In particular, Section 361 proposes to amend the definitions of CPO and commodity trading advisor (CTA) as contained in the Commodity Exchange Act (CEA), as amended, with respect to RICs. The Proposed Act has been passed by the House and awaits Senate approval.
Under the Proposed Act, the revised definition of a CPO will exclude an investment adviser to a RIC or a subsidiary of such a company, if the investment company or subsidiary invests, reinvests, owns holds or trades in commodity interests limited to only "financial commodity interests." "Financial commodity interests" are thereafter defined in the Proposed Act to mean:
a futures contract, an option on a futures contract, or a swap, involving a commodity that is not an exempt commodity or an agricultural commodity, including any index of financial commodity interests, whether cash settled or involving physical delivery.
The term "financial commodity interest" would thus include, for instance, a futures contract, option on a futures contract or swap on interest rates, treasuries, foreign exchange, stock indices, and indices based on prices or rates. It would not extend, however, to futures or swaps on agricultural or exempt commodities (e.g., energy metals, chemicals and emission allowances).
Although many RICs and their investment advisers currently operate under a different regulatory environment than other CPO registrants (assuming they utilize CFTC Rules 4.5 or 4.12(c)(3)), the Proposed Act would eliminate any further CFTC regulatory oversight for those RICs and their advisers that trade only in "financial commodity interests." De-registration as a CPO for such entities would thus be warranted if the Proposed Act were adopted as proposed.
Similarly, under the Proposed Act, the revised definition of a CTA would exclude a person who serves as an investment adviser to a RIC or a subsidiary of such a company if the commodity trading advice relates only to a "financial commodity interest," as defined above. For example, a sub-adviser that only provides advice in relation to "financial commodity interests" would no longer need to be registered as a CTA if the Proposed Act were adopted as proposed.
Further Changes to Form CPO-PQR and Form CTA-PR
In NFA Notice to Members I-14-15, NFA issued an update concerning further revisions to Form CPO-PQR and Form CTA-PR based on comments from its members. The revised forms became effective for the period ending June 30, 2014. The primary changes to each form are outlined below:
Changes to Form CPO-PQR
NFA added further guidance concerning how to calculate the CPO's (a) total assets under management and (b) total net assets under management (boxes 0250 and 0255).
- As for both calculations, the balance should include all commodity pools operated by the CPO as of the reporting date for which the CPO is required to be registered.
- In addition, the CPO should report only actual pool assets and should not include the notional value of any pools that have been allocated to sub-advisors for trading.
The revised form also added new "Supplemental Firm Information" questions concerning the CPO's investments in futures and swaps, and asks if the CPO is also an investment adviser registered with the SEC.
Under this new section, the form asks for the total net assets under management of all commodity pools operated by the CPO (box 0030).
- For this balance, the CPO should include all commodity pools operated by the CPO, including those pools that operate pursuant to an exemption or exclusion under CFTC Rule 4.13 or 4.5.
- The CPO should also only include the actual pool assets and not the notional value of any pools that have been allocated to sub-advisors for trading.
The new form also asks for the approximate percentage of total net assets under management that were allocated to futures, swaps, excess collateral cash allocated to futures and swaps, and other investments and cash (boxes 0025-0028):
- When reporting the approximate percentage in each of these categories, the CPO is asked to provide a reasonable good-faith estimate.
- A CPO that is also registered as a CTA is asked to exclude any assets attributed to separately managed or parallel managed accounts for which it already reports on the Form CTA-PR.
- Where collateral/margin is required but has not been posted as of the reporting date, the CPO should include the required collateral/margin in the appropriate investment category.
Changes to Form CTA-PR
The Form CTA-PR was amended, in part, to define the following terms, and provide guidance regarding their use in the form:
- "CTA" is defined in Section 1a(12) of the CEA.
- "Trading Program" is defined in CFTC Rule 4.10(g), wherein a person (1) directs a client's commodity interest account or (2) guides the client's commodity interest trading by means of a systematic program that recommends specific transactions.
- "Direct" is defined in CFTC Rule 4.10(f) (namely where a person is authorized to cause transactions to be effected for a client's commodity account without the client's specific authorization), and excludes any programs that consist solely of accounts for which registration is not required.
The revised form provides guidance for calculating the total number of "Trading Programs" offered by the CTA (box 0013):
- For this calculation, the CTA should use the above definition of "Trading Programs."
- For this calculation, the figure should include only trading programs for which the CTA is registered or is required to be registered.
- The CTA should exclude any programs that consist solely of accounts for which registration is not required.
The revised form provides guidance for calculating the total number of "Trading Programs" offered by the CTA under which the CTA "Directs" pool assets (box 0014):
- For this figure, the CTA should use the above definition of "Direct."
- The CTA should also exclude any programs that consist solely of pools for which the CPO is not required to be registered.
The revised form also provides guidance in calculating the total assets "Directed" by the CTA (box 0015):
- This figure should reflect the total nominal value of all assets "Directed" by the CTA in programs for which the CTA is registered or required to be registered.
- The figure should exclude, however, any assets that are attributable to pools for which the CPO is not required to be registered.
- The figure should exclude any pool assets attributed to commodity pools that the CTA operates as a CPO and already reports on the Form CPO-PQR.
The carrying broker questions (boxes 0101 and 0100) were amended to request the names and NFA identification number of each futures commission merchant, forex dealer member and retail foreign exchange dealer that carries the CTA's client accounts, which could result in a large number of such firms being listed.
The new "Supplemental Information" questions (boxes 0030 and 0025-0028) ask about the CTA's investments in futures and swaps and request a breakdown of the CTA's various investment allocations in each category:
- When reporting the approximate percentage in each of the categories, the CTA is asked to provide a reasonable good-faith estimate.
- If the CTA is also registered as a CPO, it should exclude any pool assets that are attributed to the CPO and that are reported on the Form CPO-PQR.
- Where collateral/margin is required but has not been posted as of the reporting date, the CTA should include the required collateral/margin in the appropriate investment category.
- Where notional funds have been designated to the CTA, the CTA should include those available funds in the excess collateral category.
A link to NFA Notice to Members I-14-15 is provided here.
If you have questions about these recent regulatory developments, please contact Joseph M. Mannon at +1 (312) 609 7883, Nicole M. Kuchera at +1 (312) 609 7763 or your Vedder Price attorney.
1 CPOs of registered investment companies can already obtain similar relief under CFTC Letter No. 13-51 with respect to their controlled foreign corporation subsidiaries.
2 If the Parent Pool and its Trading Subsidiary are subject to different annual report requirements (e.g., CFTC Rule 4.7(b)(3) versus 4.22(c)), the more stringent annual report requirement of CFTC Rule 4.22(c) applies.