CFTC Rescinds Exemption from CPO Registration; Forthcoming Regulations on Investment Advisers that Trade Swaps

Summary. On February 9, 2012, the Commodity Futures Trading Commission (the “CFTC”) issued final regulations (the “Final Rules”) that eliminate the exemption from registration as a commodity pool operator (a “CPO”) in CFTC Rule 4.13(a)(4). The Rule 4.13(a)(4) exemption is available to CPOs of private funds that invest in futures and other commodity interests (together, “Commodity Interests”) and that are offered only to highly sophisticated investors. The investment adviser to a fund is generally the fund’s CPO. Because “qualified purchasers” under section 3(c)(7) of the Investment Company Act of 1940 (the “ICA”) satisfy the sophistication requirement of Rule 4.13(a)(4), CPOs of 3(c)(7) funds that invest in Commodity Interests typically have relied on the Rule 4.13(a)(4) exemption. If such an adviser intends to continue to invest in Commodity Interests after the Final Rules become effective, it will need to qualify for another exemption or register with the CFTC as a CPO.

The elimination of the Rule 4.13(a)(4) exemption will, however, affect a larger group of fund advisers than those that trade Commodity Interests, because the CFTC and the SEC are now finalizing regulations mandated by the Dodd-Frank Act that will bring many over-the-counter derivatives within the jurisdiction of the CFTC. When these regulations (which are not part of the Final Rules) become effective, advisers to funds that invest in many types of swaps will be deemed CPOs, even if they do not invest in Commodity Interests. As CPOs, they will be required to register with the CFTC unless they qualify for an exemption. The revocation of the Rule 4.13(a)(4) exemption eliminates one of the most likely means by which those advisers would have been able to avoid CFTC registration.

Effective Date of Final Rules. The Final Rules will become effective 60 days after they are published in the Federal Register, which is likely to occur soon. A CPO that claims the Rule 4.13(a)(4) exemption for a fund before the effective date may continue to rely on it until December 31, 2012. Beginning on the effective date, however, a CPO will no longer be allowed to file a new claim for the Rule 4.13(a)(4) exemption. The exemption must be claimed separately for each fund, and therefore a CPO that claims the Rule 4.13(a)(4) exemption with respect to a fund before the effective date and organizes a new fund after that date will not be able to rely on the exemption for the new fund.

By December 31, 2012, a CPO that currently relies on the Rule 4.13(a)(4) exemption with respect to a fund must either cease trading Commodity Interests (and many swaps, if the regulations defining “swap” become effective by that date) in that fund, qualify for another exemption from CPO registration (see the discussion below about the Rule 4.13(a)(3) exemption), or register with the CFTC.

New Regulations Regarding Swaps. Because swaps are not yet regulated by the CFTC, investment advisers to funds that invest in swaps but not Commodity Interests are not currently CPOs and therefore are not subject to CFTC regulation. The Dodd-Frank Act expanded the definition of “commodity pool” to include funds that invest in swaps and directed the CFTC and the SEC to define “swap.” Although the agencies’ efforts to agree on a definition have been protracted and controversial, the definition is expected ultimately to encompass many over-the-counter derivatives, including swaps on broad-based securities indices and interest rate, currency, total return and most other financial swaps, but excluding “security-based swaps,” which include swaps on single securities and narrow-based securities indices.

On the effective date of the rules that define “swap” (the “Swap Regulations”), investment advisers to funds that invest in swaps will be treated as CPOs. By that date, they will need to have exited the swaps markets, claimed an available exemption from CPO registration (such as the Rule 4.13(a)(3) exemption described below), or registered as CPOs. The content and effective date of the Swap Regulations remain uncertain; they may become effective before or after December 31, 2012. Accordingly, any adviser to a fund that invests in derivatives should contact us to assess whether the instruments it trades are likely to be included in the new “swap” definition. If so, the adviser should evaluate its eligibility for the Rule 4.13(a)(3) exemption or develop a timetable for registering as a CPO.

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