In response to requirements under the Dodd-Frank Act,1 two rules were proposed which, if adopted, will (i) add new reporting requirements for registered investment advisers to private funds, commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”), and (ii) remove or limit exemptions and exclusions from registration with the Commodity Futures Trading Commission (“CFTC”) that are frequently relied on by private funds and registered investment companies and their advisers.
On January 26, 2011, the Securities and Exchange Commission (“SEC”) and the CFTC jointly issued a release proposing rules under the Investment Advisers Act of 1940 (the “Advisers Act”) and the Commodity Exchange Act (“CEA”) to implement certain requirements under the Dodd-Frank Act. The proposed rules would require SEC-registered investment advisers and dual SEC/CFTC registrants that advise private funds to provide specified information about the private funds they advise on a new Form PF (the “Joint Proposed Rules”).2
On February 1, 2011, the CFTC published a notice of proposed rulemaking (the “CFTC Proposed Rules”)3 that would rescind Rules 4.13(a)(3) and (4), exemptions frequently relied on by private fund advisers to avoid registration as CPOs. In addition, the CFTC Proposed Rules would limit the use of Rule 4.5 as an exclusion for registered investment companies that may otherwise qualify as CPOs and would impose additional reporting and disclosure requirements on CPOs and CTAs.
The Joint Proposed Rules; New Form PF
The Joint Proposed Rules would require SEC-registered investment advisers to private funds, as well as CPOs and CTAs that advise private funds and who are also SEC-registered investment advisers, to electronically file a new Form PF on either an annual or a quarterly basis (depending on the aggregate amount of assets in the private funds managed by each adviser). The SEC does not intend to make public Form PF information that is identifiable to any particular adviser or private fund, although the SEC may use Form PF information in an enforcement action. Form PF data is intended to provide the Financial Stability Oversight Counsel (“FSOC”) with a broader understanding of the private fund industry to enable regulators to identify red flags requiring further review of a particular institution and, as explicitly required by Section 404 of the Dodd-Frank Act, to assist the FSOC in its assessment of systemic risk in the U.S. financial system. The release provides that it is currently anticipated that Form PF filings will be required starting in early 2012.
Who Must File Form PF
The Joint Proposed Rules would require an SEC-registered investment adviser to one or more private funds4 to report certain basic information about itself and the private funds it manages on Form PF once each year. Investment advisers that are exempt from registration under the Advisers Act would not be required to file Form PF. The Joint Proposed Rules would also create a category of “Large Private Fund Advisers,” each of whom would be required to submit a more detailed Form PF on a quarterly basis, which would include additional systemic risk-related information concerning the private funds they manage. The Joint Proposed Rules define three types of Large Private Fund Advisers:
- an adviser managing hedge funds5 that collectively have at least $1 billion in assets as of the close of business on any day during the reporting period for the required report;
- an adviser managing a private liquidity fund and having combined private liquidity fund and registered money market fund assets of at least $1 billion as of the close of business on any day during the reporting period for the required report; and
- an adviser managing private equity funds that collectively have at least $1 billion in assets as of the end of a quarter during the reporting period for the required report.
The SEC and CFTC are proposing to implement these thresholds so that the group of Large Private Fund Advisers would be relatively small in number but would represent a large majority of their respective industries based on assets under management. In the release setting forth the Joint Proposed Rules, it is estimated that this group of advisers would include approximately 200 U.S.-based advisers to hedge funds, representing over 80% of the U.S. hedge fund industry based on assets under management, and approximately 250 U.S.-based advisers to private equity funds, representing approximately 85% of the U.S. private equity fund industry based on committed capital.
In order to prevent an adviser from avoiding the proposed Large Private Fund Adviser reporting requirements, the Joint Proposed Rules would require each adviser to aggregate: (1) assets of managed accounts advised by the adviser that pursue substantially the same investment objective and strategy and invest in substantially the same positions as the private fund, and (2) assets of that type of private fund advised by any of the adviser’s related persons. The adviser would be required to exclude any account that is solely invested in other funds (i.e., internal or external fund of funds) in order to avoid duplicate reports.
The Joint Proposed Rules also provide that if the adviser’s principal office and place of business are outside of the United States, then the adviser may exclude any private fund that during the last fiscal year was neither a United States person nor offered to, or beneficially owned by, any United States person.
CPOs and CTAs that are not also SEC-registered investment advisers would be required to file proposed Form CPO-PQR (for CPOs) and proposed Form CTA-PR (for CTAs) reporting similar information as Form PF requires. Similar to the SEC, the CFTC would keep certain information reported on Forms PF, CPO-PQR and CTA-PR confidential. The CFTC Proposed Rules would allow CPOs and CTAs that are also registered with the SEC as investment advisers and advise one or more private funds to satisfy certain proposed CFTC filing requirements by filing Form PF with the SEC.
Types of Information to Be Provided on Form PF
Section 1 of Form PF would require each adviser required to file such form to report identifying information about the adviser and basic aggregate information about the private funds managed by the adviser (such as total and net assets under management and the amount of those assets attributable to certain types of private funds). The adviser would also be required to report certain identifying and other information about each private fund it advises, including the amount of its assets, the aggregate notional value of its derivative positions, its borrowings (including the identity of and amount owed to each creditor to which the fund owed an amount equal to or greater than 5% of the fund’s net asset value as of the reporting date), the concentration of its investor base and performance information. Section 1 also requires specific disclosure relating to hedge funds managed by the adviser, including the funds’ investment strategies, the percentage of each fund’s assets managed using certain computer-driven trading algorithms, significant trading counterparty exposures, and trading and clearing practices.
Form PF would also require each Large Private Fund Adviser to complete additional sections of the form on a quarterly basis, depending on the type of funds that the Large Private Fund Adviser manages.
- Hedge Funds. Large Private Fund Advisers to hedge funds would be required to report certain aggregate information about those hedge funds, including the market value of assets invested (on a long and short basis) in different types of securities and commodities, the duration of fixed income portfolio holdings, the turnover rate of the adviser’s aggregate portfolios during the reporting period and a geographic breakdown of investments. For a Large Private Fund Adviser managing a hedge fund with a net asset value of at least $500 million as of the close of business on any day during the reporting period (a “qualifying hedge fund”),6 additional information would need to be reported regarding such fund’s portfolio liquidity, concentration of positions, collateral practices with significant counterparties, and the identity of, and clearing relationships with, the three central clearing counterparties to which the fund has the greatest net counterparty credit exposure. The Joint Proposed Rules would also require Large Private Fund Advisers to qualifying hedge funds to provide data regarding certain hedge fund risk metrics, financing and investment information, monthly breakdown of its secured and unsecured borrowing and its derivatives exposures, investor composition, and liquidity terms (including side pocket and gating arrangements and a breakdown of each fund’s net assets that are locked in for different periods of time).
- Liquidity Funds. Large Private Fund Advisers to private liquidity funds would be required to report certain information about the valuation methods and pricing methodologies used to determine the net asset value of each liquidity fund they manage and whether the fund as a matter of policy is managed in compliance with certain provisions of rule 2a-7 under the Investment Company Act.7 Form PF would also elicit information regarding the private liquidity fund’s portfolio (including monthly net asset value, weighted average maturity, weighted average life and 7-day gross yield) and the amount of the fund’s assets invested in different types of instruments. Details about any secured or unsecured borrowing of the liquidity fund and whether the fund has in place a committed liquidity facility would also need to be disclosed. Form PF would require disclosure of certain information regarding the concentration of the private liquidity fund’s investor base, the fund’s gating and redemption policies, and investor liquidity.
- Private Equity Funds. Large Private Fund Advisers to private equity funds would be required to report certain information about the portfolio companies in which the funds that they manage invest, including leverage, debt-to-equity ratios, maturity profile of debt, and the identity of institutions providing bridge financing and the amount of that financing. Form PF would require disclosure about the fund’s borrowings and guarantees and whether the fund or any of its portfolio companies experienced an event of default on any of its debts during the reporting period. If the fund invests in any financial industry portfolio company, the adviser would be required to report the fund’s name, its debt-to-equity ratio and the percentage of the portfolio company beneficially owned by the fund. Form PF would also require a breakdown of each private equity fund’s investments by industry and geography and whether any of the adviser’s related persons co-invest in any of the fund’s portfolio companies.
Expected Dates for Commencement of Filing Form PF
Under the Joint Proposed Rules, it is anticipated that Large Private Fund Advisers would begin filing quarterly Form PFs within 15 days after December 31, 2011, and within 15 days after the end of each calendar quarter thereafter. Each smaller private fund adviser would make its first filing of Form PF within 90 days of the end of its first fiscal year occurring on or after December 31, 2011 (by March 31, 2012 for most smaller private fund advisers). Annual updates for smaller private fund advisers would be due no later than the last day on which the adviser may timely file its annual updating amendment to Form ADV (90 days after the end of the adviser’s fiscal year). A newly registered adviser’s initial Form PF would need to be submitted within 15 days following the end of its next occurring calendar quarter after registering with the SEC.
The release setting forth the Joint Proposed Rules invites comments on various aspects of the Joint Proposed Rules, including whether there are additional data points about a private fund’s activities that are relevant to the assessment of systemic risk and should be included in the new Form PF, and, conversely, whether any data points included in the proposed Form PF are not particularly helpful in identifying characteristics of systemic risk. Any comments must be submitted to the SEC or CFTC within 60 days from publication in the Federal Register.
The CFTC Proposed Rules
The CEA defines a commodity pool as a collective investment vehicle that is operated for the purpose of trading in commodity interests, including exchange-traded futures, options on futures and, now, swaps (collectively, “Commodity Interests”).8 The CEA requires the operator of a commodity pool to register with the CFTC as a CPO, and requires certain persons that provide advice about trading Commodity Interests to register with the CFTC as a CTA, subject to various exemptions and exclusions.
Operators and advisers of private funds that trade Commodity Interests have frequently relied on exclusions and exemptions from CPO and CTA registration. The most commonly used of these exemptions, Rules 4.13(a)(3) and (4), were introduced in 2003 as part of the CFTC’s de-regulatory cycle that followed passage of the Commodity Futures Modernization Act of 2000. The CFTC Proposed Rules would rescind those exemptions from CPO registration, the effect of which may be to require registration and disclosure by many sponsors and advisers to private funds that trade Commodity Interests. The CFTC Proposed Rules would also significantly narrow the exclusion under Rule 4.5 commonly relied on by registered investment companies and their advisers, and would reinstate a filing requirement to claim the exclusion.
Below we summarize the CFTC rules affected and the impact the CFTC Proposed Rules could have on operators and advisers of entities that may be treated as commodity pools.
Elimination of the De Minimis and Sophisticated Investor CPO Exemptions
Rule 4.13(a)(3) (“De Minimis Exemption”) exempts persons from registration as a CPO if interests in the commodity pool (i) are exempt from registration under the Securities Act of 1933 (“‘33 Act”) and are offered or sold without marketing to the public in the United States; (ii) are offered only to persons who are reasonably believed to be accredited investors9 or qualified purchasers;10 (iii) the commodity pool trades a minimal amount of commodity futures (as determined under certain quantitative thresholds); and (iv) the person does not market participations as or in a vehicle for trading in the commodity futures markets.
Rule 4.13(a)(4) (“Sophisticated Investor Exemption”) exempts persons from registration as a CPO if interests in the commodity pool (i) are exempt from registration under the ‘33 Act and are offered or sold without marketing to the public in the United States and (ii) are offered only to natural persons who are reasonably believed to be qualified eligible persons (“QEPs”)11and non-natural persons who are reasonably believed to be QEPs or accredited investors.
The CFTC Proposed Rules would eliminate both the De Minimis Exemption and Sophisticated Investor Exemption. Accordingly, operators of funds previously relying on the De Minimis Exemption or the Sophisticated Investor Exemption would be required to register with the CFTC, absent another exemption. Registrants are required to become members of the National Futures Association (“NFA”) and are subject to various related ongoing disclosure, reporting and recordkeeping requirements under Part 4 of the CFTC rules.12 The CFTC staff has preliminarily estimated that anywhere from 1,000 to 5,000 entities could be required to register as CPOs because of the loss of the De Minimis Exemption alone.
Removal of the Related CTA Exemption
The CFTC Proposed Rules would remove the Rule 4.14(a)(8)(i)(D) exemption to reflect the elimination of the De Minimis Exemption and the Sophisticated Investor Exemption.13 Rule 4.14(a)(8)(i)(D) provides an exemption from CTA registration for an adviser that (i) advises CPOs that have claimed exemption from registration under Rules 4.13(a)(3) and (4); (ii) provides Commodity Interest trading advice solely incidental to its business of providing securities or other investment advice to qualifying entities, collective investment vehicles and commodity pools as described in Rule 4.14(a)(8)(i); and (iii) does not otherwise hold itself out as a CTA.
Under the CFTC Proposed Rules, advisers who previously relied on Rule 4.14(a)(8)(i)(D) would be required to register as CTAs to the extent they qualified for that exemption because of the exemption for CPOs under Rules 4.13(a)(3) or (4). This may impact a large number of advisers to private funds, although other exemptions from CTA registration may be available.
Exclusion for Registered Investment Companies
Rule 4.5 generally excludes entities that are “otherwise regulated,” such as registered investment companies, state-regulated insurance companies, banks and pension plans, and various other entities (collectively “qualifying entities”) from the definition of a CPO notwithstanding the amount of Commodity Interests trading such entities may engage in. The CFTC made this proposal due to its concern that under Rule 4.5 registered investment companies are permitted to, and do, offer “futures-only investment products without Commission oversight.”14
The CFTC Proposed Rules would amend Rule 4.5 to reinstate certain limitations on the exclusions that were in effect prior to 2003. These limitations are proposed to be reinstated for registered investment companies only. The reinstated Rule 4.5 would only provide a registered investment company an exclusion from the definition of CPO if it files a notice of eligibility providing, among other things, that it (i) uses Commodity Interests solely for bona fide hedging purposes or it meets the “Five Percent Test”15; and (ii) has not, and will not, market participations to the public as or in a commodity pool or otherwise as or in a vehicle for trading in the commodity futures, commodity options, or swaps markets. The notice of eligibility must be affirmed annually.
What Exemptions Will Remain?
If the CFTC Proposed Rules are promulgated as proposed, operators and advisers will still have certain exemptions from CPO and CTA registration available to them. However, many of the remaining exemptions for CPOs are partial only — they provide relief from certain disclosure obligations to investors but not from CPO registration itself. For example, Rule 4.7 exempts CPOs from certain reporting requirements provided that all of their investors are QEPs.16 Exemptions from CTA registration will still be available as well. These include Rule 4.14(a)(10), which provides an exemption from CTA registration for any person who meets the criteria of Section 4m(1) of the CEA. That section exempts an adviser who has not furnished commodity trading advice to more than 15 persons for the preceding 12 months and who does not hold itself out generally to the public as a commodity trading adviser. For these purposes, a fund counts as one person (no look-through). The exclusion in Rule 4.5 would also remain in place, but as discussed above will be significantly narrowed as to registered investment companies. Furthermore, under the CFTC Proposed Rules, a person claiming relief under Rule 4.5 or what remains of Rule 4.13 or Rule 4.14 would be required to file with the NFA annual notices of exemption or exclusion.
Additional Reporting and Disclosure Requirements
The CFTC Proposed Rules would impose additional reporting and disclosure requirements on CPOs and CTAs. As discussed above, the CFTC proposes to require CPOs and CTAs that are not also SEC-registered investment advisers to complete and submit forms CPO-PQR and CTA-PR. These forms are to be submitted to the NFA and require information that is “generally identical” to information required by Form PF. Also, consistent with the SEC’s approach in Form PF, a tiered approach is applied to CPOs and CTAs such that a CPO or CTA will be required to provide varying levels of information, depending on its size and the size of its pool.
Commodity pools with participants who are only QEPs previously were exempt from the requirement to include certified financial statements in annual reports; that exemption would be rescinded by the CFTC Proposed Rules. The QEP definition would also incorporate the Regulation D accredited investor standard by reference. Finally, in light of the expansion of the CFTC’s jurisdiction to include swaps, the CFTC Proposed Rules would amend mandatory CPO and CTA Risk Disclosure Statements to describe certain risks specific to swap transactions, such as limited liquidity and valuation difficulties that may hinder participants’ ability to liquidate their accounts or redeem their interests in the commodity pool.
The proposed rules that are discussed in this alert would impose significant new requirements on many investment advisers, CPOs and CTAs. They should pay careful attention to the proposed rules and how they might impact their businesses, and should consider commenting on areas of concern.
Please direct any questions to any of the listed lawyers or to any other Bingham lawyer with whom you ordinarily work on related matters.
Geoffrey F. Aronow, Partner, Broker-Dealer Group
Richard A. Goldman, Partner, Investment Management
Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area
Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area
Tim Burke, Practice Group Leader, Broker-Dealer Group; Co-chair, Financial Services Area