CFTC Adopts Final Rule Amendments for CPOs and CTAs

On August 13, 2013, the CFTC adopted final rule amendments to accept compliance with the disclosure, reporting and recordkeeping regime administered by the SEC as substituted compliance for substantially all of part 4 of the CFTC’s regulations that are applicable to CPOs of funds registered under the Investment Company Act of 1940. [1] The adopting release broadens the approach set forth in the harmonization proposals issued by the CFTC in February 2012 [2] and provides, among other things, that if the CPO of registered funds satisfies all applicable SEC rules for such funds as well as certain other conditions, it will be deemed in compliance with the CFTC’s rules regarding:

• delivery of disclosure documents to each prospective participant in any pool that a CPO operates (Section 4.21); [3]
• distribution of account statements to each participant in any pool that a CPO operates (Sections 4.22(a) and (b));
• provision of information that must appear in a CPO’s disclosure documents (Section 4.24), including performance disclosures (Section 4.25); and
• the use, amendment and filing of disclosure documents (Section 4.26).

Additionally, the CFTC’s final rule amendments modify certain CFTC disclosure and reporting requirements that are applicable to all CPOs and CTAs:

• All CPOs will be permitted to use third-party service providers to maintain their books and records;
• The requirement that a CPO receive a signed acknowledgement of receipt of a disclosure document from each pool participant is being rescinded for all CPOs; and
• CPOs and CTAs will be required to update their disclosure documents under Sections 4.26 and 4.36 on a 12-month basis instead of a nine-month basis.

Simultaneously, the SEC’s Division of Investment Management issued guidance summarizing its views regarding certain disclosure and compliance matters relevant to registered funds that use derivatives that are commodity interests under the CFTC rules. [4] Both agencies have expressed an intent to harmonize the disclosure and reporting requirements of the CFTC and the SEC in a manner that would result in the provision of material information to investors without imposing duplicative, inconsistent and burdensome requirements on CPOs of registered funds.

Certain rule amendments, including the removal of the requirement to obtain a signed acknowledgment of delivery of disclosure documents, will become effective upon publication in the Federal Register. All other amendments, including those related to substituted compliance for CPOs of registered funds, will become effective 30 days after they are published in the Federal Register. The timeline for compliance with the substituted compliance regime and the revised rules, as discussed below, varies by rule and according to the type of the registered entity.

Background

In February 2012, the CFTC adopted rule amendments that significantly limited the availability of the exclusion from the definition of “commodity pool operator” (“CPO”) pursuant to Section 4.5 of the CFTC’s rules (the “2012 Final Rule”). [5] Specifically, CPOs of investment companies registered with the SEC (“funds”) under the Investment Company Act of 1940 (the “1940 Act”) that exceed a de minimis threshold of commodity interest trading, excluding bona fide hedging, or which market themselves as commodity pools or other commodity investments, are required to register with the CFTC. Additionally, the 2012 Final Rule required CPOs and commodity trading advisors (“CTAs”) to file reports regarding commodity pool and certain other assets under their management and increased disclosure requirements for CPOs and CTAs. Concurrent with that modification, the CFTC proposed rule amendments to harmonize SEC and CFTC disclosure, reporting and recordkeeping requirements that apply to CPOs of funds that are subject to dual registration. In response to various comment letters and following interactions between the staffs of the CFTC and SEC, the CFTC promulgated the rule amendments in the adopting release.

Harmonization of CFTC and SEC Compliance Obligations for CPOs of Funds

In the adopting release, the CFTC noted that “its understanding of [funds] and their uses of commodity interests continues to evolve as it gains experience regarding [funds], and their regulation and operation.” The CFTC went on to state its belief that “at this time . . . the prudent approach is to provide a substituted compliance regime based largely upon adherence to the regime administered by the SEC as [the CFTC] continues to expand its knowledge of [funds] and their use of commodity interests.”

Conditions for CPOs of Funds Electing to Comply Through Substituted Compliance

Under the final rules, a CPO of a fund may comply with CFTC requirements applicable to all CPOs or elect to comply through substituted compliance, subject to the following conditions specified in amended Section 4.12(c):

• The CPO of a fund will be required to file notice of its reliance on the substituted compliance regime outlined in Section 4.12 with the National Futures Association (“NFA”);
• The CPO of a fund with less than three years operating history will be required to ensure that the fund discloses the performance of all accounts and pools that are managed by the CPO and have investment objectives, policies and strategies substantially similar to those of the offered pool;
• The CPO of a fund will be required to file the financial statements that it prepares pursuant to its obligations with respect to the SEC with the NFA; and
• If the CPO of a fund uses or intends to use third-party service providers for recordkeeping purposes, it will be required to file notice with the NFA.

Obligations to Deliver and Obtain Acknowledgement of Disclosure Documents Exempted Through Substituted Compliance

Section 4.21 requires a CPO to deliver a disclosure document to each prospective participant and obtain a signed acknowledgment of receipt before accepting or receiving funds from that participant. The federal securities laws require delivery of a “statutory” prospectus to each fund investor no later than the confirmation of the transaction and do not require a signed acknowledgment from an investor. The final rule will deem CPOs of funds compliant with the provisions of Section 4.21 if they provide disclosures to participants and prospective participants that comply with the provisions of the 1940 Act, the Securities Act of 1933 (the “Securities Act”), the Securities Exchange Act of 1934, the regulations promulgated thereunder, and any guidance issued by the SEC or any division thereof, regarding disclosure, reporting and recordkeeping by funds (collectively, the “SEC Fund Rules”). The adopting release notes the following provisions of the SEC Fund Rules for CPOs of funds that elect to satisfy their CFTC obligations through substituted compliance:

• Open-End Funds. The SEC Fund Rules allow open-end funds to provide a summary prospectus, provided that the statutory prospectus and other information are available on an internet website, the address of which is provided on the cover page or at the beginning of the summary prospectus. In addition, the SEC requires funds to provide paper copies of the statutory prospectus, statement of additional information and shareholder reports upon request at no cost.
• Closed-End Funds. Under the SEC Fund Rules, CPOs of closed-end funds are not required to maintain a current disclosure document if they are not soliciting participants for that pool.
• Funds Organized as Series Entities. The SEC permits funds organized as series entities with inter- series limitation of liability to include multiple series in a single registration statement while permitting reporting and disclosure on a series-by-series basis, which varies from the requirements under the existing CFTC rules.

Obligation to Distribute Account Statements Exempted Through Substituted Compliance

Section 4.22(a) requires every CPO to distribute an account statement periodically to each participant in each pool that it operates. Section 4.22(b) further requires that account statements be distributed at least monthly for pools with net assets greater than $500,000 and at least quarterly for all other pools. The final rule amendments provide relief to CPOs of funds from the requirement to send monthly financial statements, [6] provided that the fund’s current net asset value per share is available to investors, and provided also that the fund furnishes semi-annual and annual reports to investors and files periodic reports as required by the applicable SEC Fund Rules.

Required Information in Disclosure Documents Exempted Through Substituted Compliance

Sections 4.24 and 4.25 detail information that must appear in a CPO’s disclosure documents, including performance disclosures. The final amendments permit CPOs of funds to satisfy the requirements under Sections 4.24 and 4.25 by complying with applicable SEC Fund Rules, including:

• Use of Summary Prospectus. The final amended rule deems a CPO of funds compliant with the provisions of Sections 4.24 and 4.25 if the CPO complies with the applicable SEC Fund Rules relating to statutory prospectuses and/or summary prospectuses.
• Cautionary Statement. In lieu of the standard cautionary statement provided in Section 4.24(a), a CPO of funds is permitted to use the cautionary statement prescribed in SEC Rule 481 under the Securities Act. Although not required in the wording of the final rules, the adopting release suggests that such statement should also refer to the CFTC. [7]
• Risk Disclosure Statement. The risk disclosure statement under Section 4.24(b) sets forth standard risks associated with the use of commodity interests. Because the specific risks delineated in the prescribed cautionary statement may not reflect those associated with investment in a fund, the CFTC has decided not to require CPOs of funds to include such standard risk disclosure statements and will deem CPOs of funds compliant with Section 4.24(b) if they comply with the SEC Fund Rules, including disclosure requirements in Section 10 of the Securities Act and other provisions of the Securities Act, the 1940 Act, Rule 498 under the Securities Act and SEC Forms N-1A and N-2.
• Risk Disclosure. Section 4.24(g) requires a CPO to include a discussion of the principal risk factors of participation in the offered commodity pool. The CFTC has determined that the disclosure requirements of SEC Forms N-1A and N-2 and in applicable SEC guidance should satisfy the CFTC’s concern that participants receive complete and accurate disclosure about the risks associated with investment in commodity interests. However, the adopting release notes that, if a CPO of funds relies on substituted compliance in this area, the disclosures to prospective participants should include true, accurate and complete information describing the commodity-interest activities of the fund, including a discussion of the material risks of those assets and activities.
• Break-Even Disclosure. Section 4.24(d)(5) requires CPOs to include in the forepart of the disclosure document the “break-even point” [8] per unit of initial investment. Considering that the information required by the SEC (e.g., SEC Form N-1A, item 3 requires similar disclosures on the same types of fees and costs), the amended rule deems CPOs of funds compliant with the requirements under Section 4.24(d)(5) if they comply with the SEC Fund Rules.
• Past Performance Disclosure. Section 4.24(n) requires CPOs to disclose past performance information on, among other things, aggregate gross capital subscriptions to the pool, the pool’s current net asset value, the largest monthly draw-down during the most recent five calendar years and year-to-date; the worst peak-to-valley draw-down during the most recent five calendar years and year-to-date; and the annual and year-to-date rate of return for the pool for the most recent five calendar years and year-to-date, including a bar graph depicting such rates of return. Although most performance-related disclosures are similar under the CFTC and the SEC regimes, the agencies approach the issue of past performance disclosures differently. In particular, when an offered pool has less than a three-year operating history, the CPO must disclose the past performance of each other pool it operates, while the applicable SEC Fund Rules do not require disclosure of past performance for any fund other than the offered fund, and if such information is provided, it must not be misleading under applicable SEC Fund Rules. The amended rule deems CPOs of funds generally compliant with the past performance reporting requirement if they comply with applicable SEC Fund Rules. However, in order for CPOs of funds with less than three years of operations to be in compliance with the three-year look-back, the CPO must disclose the performance of all accounts and pools that are managed by the CPO and that have investment objectives, policies and strategies substantially similar to the offered pool.
• Fee Disclosures. Section 4.24(i) requires CPOs to include in the disclosure document a complete description of each fee, commission and other expense which the CPO knows has been incurred or expects to be incurred. Because the same types of fees and costs are disclosed through SEC- required disclosures and item 21 of SEC Form N-1A requires a discussion of brokerage commissions paid by the fund during its three most recent fiscal years, the final rule deems CPOs of funds compliant with the requirements under Section 4.24(d)(5) if they comply with the SEC Fund Rules.

Filing and Updating Disclosure Documents Obligations Exempted Through Substituted Compliance

• Effective Time Period for Disclosure Documents. Under amended Section 4.26(a)(2), CPOs and CTAs are required to update a pool’s disclosure document within 12 months (modified from nine months under the current rules) of the document’s date of first use. Absent harmonization, dual registrants would be required to comply with the disparate deadlines applicable under CFTC rules and the updating process implemented by the SEC pursuant to Section 10(a)(3) of the Securities Act and Rule 485 thereunder, which require open-end funds to amend their registration statements annually but provides four months after the end of the fiscal year to do so. By electing substituted compliance, CPOs of funds in compliance with the applicable time frames under the SEC regime will be deemed to satisfy the effective time period for disclosure documents in Section 4.26.
• Interim Updating of Disclosure Documents. Section 4.26(c) requires a CPO to correct material inaccuracies in a disclosure document within 21 days of the date upon which the CPO first becomes aware of the defect. In contrast, the federal securities laws prohibit the offer or sale of the shares of a fund by means of a materially misleading prospectus and impose liability for the use of such a prospectus. Because of the substantively similar goals of the two regulatory regimes to ensure that participants receive accurate information in a timely manner, the CFTC will deem CPOs of funds that adhere to the disclosure requirements under SEC Fund Rules to be in compliance with Section 4.26(c).
• Review of Disclosure Documents by NFA. Section 4.26(d) requires a CPO to file its disclosure documents and amendments with the NFA no less than 21 calendar days prior to delivery. The final rule deems CPOs of funds compliant with Section 4.26(d) if they are in compliance with the SEC Fund Rules. A CPO of a fund relying on substituted compliance must also file a notice with the NFA of its use of the substituted compliance regime.

Controlled Foreign Corporation

The CFTC reaffirmed in the final rule that funds may continue to use wholly owned non-U.S. subsidiaries that engage in commodity interest transactions, referred to as controlled foreign corporations (“CFCs”) and that such CFCs, depending on their investment activities, may fall within the statutory and regulatory definitions of a “commodity pool.” Because a fund using a CFC to implement its investment strategy is required to comply with the SEC Fund Rules, including disclosing information in its prospectus about the fund’s investment in the CFC and the principal risks associated with such CFC investment, a CFC will not be required under the final rule to prepare a separate disclosure document if the fund provides full disclosure of material information regarding the activities of its CFC as required by the SEC Fund Rules.

In addition, provided that the fund consolidates the financial statements of the CFC with its financial statements that are filed with the NFA, the CFC will not be required to file separate financial statements.

Modifications to CFTC Reporting and Disclosure Requirements Applicable to all CPOs and CTAs

Use of Third-Party Service Providers to Maintain Books and Records

The final rule amends Sections 4.23 and 4.7(b)(4) to allow all CPOs to utilize the services of third parties with respect to the maintenance of books and records, as long as at the time that such CPO registers with the CFTC, or delegates its recordkeeping obligations, whichever is later, the CPO files a statement with the CFTC describing the delegated record keeper and maintains timely access to those records as required by the CFTC rules.

Rescission of Signed Acknowledgement Requirement for Receipt of Disclosure Documents

The final rule also rescinds the requirement under Section 4.21(b) that all CPOs obtain a signed acknowledgment of receipt of disclosure documents.

Cycle for Updating Disclosure Documents

The final rule adopts an important amendment to the disclosure document update cycle for a wide range of funds and other investment vehicles. Under amended Sections 4.26 and 4.36, all CPOs and CTAs will be permitted to use a disclosure document for up to 12 months instead of nine months.

Compliance Timeline

CPOs of Funds Electing Substituted Compliance

Compliance will be required with the conditions adopted in Section 4.12(c)(3)(i) for open-end funds beginning when a fund files with the SEC an initial registration statement on Form N-1A or, for an existing fund, its first post-effective amendment that is an annual update to an effective registration statement on Form N-1A. Compliance will be required when a closed-end fund files an initial registration statement with the SEC or, for existing closed-end funds, when the closed-end fund is required to update its registration statement.

Compliance with Forms CPO-PQR and CTA-PR

Consistent with the 2012 Final Rule, CPOs of funds must begin to comply with amended Section 4.27, which requires the filing by CPOs and CTAs of CFTC Forms CPO-PQR and CTA-PR, 60 days after the publication of the adopting release in the Federal Register.

SEC Guidance Update on Disclosure and Compliance Matters for Funds that Invest in Commodity Interests

On August 13, 2013, the SEC’s Division of Investment Management issued a guidance update to assist funds that invest in commodity interests in preparing disclosure filings and in their consideration of compliance issues. The guidance addresses, among other things, the following areas:

• Disclosure of Derivatives and Associated Risks. The Division highlights its concern that funds adequately disclose the risks associated with investments in commodity interests and reiterates its views that all funds that use or intend to use derivative instruments should assess, on an ongoing basis, the accuracy and completeness of their derivatives-related disclosure, including, among other things, whether the disclosure is presented in an understandable manner using plain English, whether the disclosure is tailored to the types of derivatives used by the fund, the extent of their use and the purpose for using derivative transactions.
• Performance Presentations. Under the 1940 Act, a fund is not prohibited from including in its prospectus information concerning the performance of private accounts and other funds managed by the fund’s adviser that have substantially similar investment objectives, policies and strategies to the fund, provided that the information is not presented in a misleading manner and does not obscure or impede understanding of information that is required to be included in the fund’s prospectus. The guidance emphasizes that a fund, such as a newly registered fund that invests in commodity interests, is responsible for ensuring that such information is not materially misleading. Specifically, the guidance notes that a fund should not exclude the performance of any other funds or private accounts that have substantially similar investment objectives, policies and strategies if the exclusion would cause the performance shown to be materially higher or more favorable than would be the case if the funds or accounts were included.
• Legend Requirement. The guidance clarifies that a fund that invests in commodity interests may include in the plain English legend required by Rule 481 under the Securities Act language that indicates that the CFTC (in addition to the SEC) has not approved or disapproved of the securities or passed upon the accuracy or adequacy of the disclosure in the prospectus.
• Compliance and Risk Management. The guidance notes that funds using commodity interests to implement their investment objectives and policies are subject to compliance obligations required by Rule 38a-1 under the 1940 Act and should ensure policies and procedures to effectively manage those derivatives, including their associated risks. In addition, day-to-day responsibility for managing a fund’s portfolio, including any commodity interests and their associated risks, rests with the fund’s investment adviser, which is subject to the obligation to maintain written compliance policies and procedures under Rule 206(4)-7(a) under the Investment Advisers Act of 1940. Finally, because a 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, funds are required to disclose in the statement of additional information the extent of the board’s role in the risk oversight of the fund, such as how the board administers its oversight function. The guidance also notes that a Risk and Examination Office has recently been created within the Division and is responsible for analyzing and monitoring the risk management activities of investment advisers, investment companies and the investment management industry as well as new products.

Endnotes:

[1] Harmonization of Compliance Obligations for Registered Investment Companies Required to Register as Commodity Pool Operators, 17 CFR Part 4 (August 13, 2013), available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister081213.pdf.
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[2] See Harmonization of Compliance Obligations for Registered Investment Companies Required to Register as Commodity Pool Operators, 77 FR 11345 (February 24, 2012).
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[3] Unless otherwise noted, all section references herein refer to sections in the CFTC’s rules.
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[4] U.S. Securities and Exchange Commission, Division of Investment Management, Disclosure and Compliance Matters for Investment Company Registrants That Invest in Commodity Interests (August 2013), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-05.pdf. “Commodity interest” includes commodity futures, commodity options contracts and swaps. See 17 CFR 1.3(yy).
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[5] See Commodity Pool Operators and Commodity Trading Advisors: Compliance Obligations, 77 FR 11252 (February 24, 2012). For a detailed discussion of the 2012 Final Rule, see our Memorandum to Clients, dated February 22, 2012, entitled “CFTC Adopts Final Rule Amendments Regarding Registration and Reporting Requirements for CPOs and CTAs and Issues Regulatory Harmonization Proposal”, available at http://www.sullcrom.com/CFTC-Adopts-Final-Rule-Amendments-02-22-2012.
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[6] Although the adopting release refers to “financial statements,” the CFTC appears to mean “account statements.” The amended Section 4.12(c)(3)(ii) provides “[e]xemption from the Account Statement distribution requirement of §§ 4.22(a) and (b)” subject to the conditions listed therein.
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[7] As suggested in the adopting release, the statement would read either as:

The guidance issued by the SEC’s Division of Investment Management and discussed under “SEC Guidance Update on Disclosure and Compliance Matters for Funds That Invest in Commodity Interests” herein indicates that such modifications to the legend may be made by funds.
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[8] Section 4.10(j) defines the break-even point as “the trading profit that a pool must realize in the first year of a participant’s investment to equal all fees and expenses such that such participant will recoup initial investment, as calculated pursuant to rules promulgated by a registered futures association pursuant to Section 17(j) of the [Commodity Exchange Act].”
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