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CFTC Adopts Statutory Disqualification Requirement for Exempt CPOs

June 16, 2020

The Commodity Futures Trading Commission voted on June 4 to adopt rules prohibiting exempt commodity pool operators and their principals from operating commodity pools if they are subject to any of the statutory disqualifications under Section 8a(2) of the Commodity Exchange Act.

In an effort to reduce the risk posed to investors that could arise when a person subject to a statutory disqualification operates a commodity pool pursuant to an exemption from registration, the Commodity Futures Trading Commission (CFTC) has issued a final rule to address what it views as a regulatory gap between standards applicable to registered commodity pool operators (CPOs) and those applicable to exempt CPOs. The rule revises the eligibility criteria in CFTC Regulation 4.13 to prohibit a person who wishes to claim exemptive relief under this regulation and its principals from being subject to a statutory disqualification set forth in Section 8a(2) of the Commodity Exchange Act, as amended (CEA).

Notably, the rule does not apply to family office vehicles, given that a family office is prohibited from soliciting non-family members or clients to participate in its commodity pools, limiting the family office’s contact with the general public, thereby reducing the CFTC’s customer protection concerns in this context.[1] The rule also does not apply to CPOs excluded from the definition of CPO or exempt from registration pursuant to CFTC Regulation 4.5.

BACKGROUND

Pursuant to Section 4m(1) of the CEA, any person who satisfies the definition of a CPO is generally required to register as such with the CFTC,[2] and persons who satisfy the definition of “principal” must be approved by the National Futures Association (NFA). However, CPO registration may be precluded, and a principal may not be approved, if the CPO or principal is subject to a statutory disqualification under Section 8a(2) or 8a(3) of the CEA.[3]

While registration is generally required for CPOs, CFTC Regulation 4.13 provides several exemptions from registration, including an exemption for persons who operate pools

  • for which the person does not receive compensation for operating the pool, so long as the person operates one pool at a time, is not otherwise required to register with the CFTC, and is not a business affiliate of any person required to register with the CFTC, and does not conduct any advertising in connection with the pool;
  • with no more than 15 participants at any time and whose gross capital contributions for units of participation in all of the pools the person operates in the aggregate do not exceed $400,000;
  • with a de minimis exposure to commodity interests;
  • for which the person acts as a director or trustee with respect to a pool whose operator is registered as a CPO and is eligible for the relief under CFTC Regulation 4.12(c); and
  • that are family office vehicles.

With the exception of family office vehicles, a person wishing to avail itself of an exemption pursuant to CFTC Regulation 4.13 must affirmatively claim such exemption by making a notice filing pursuant to CFTC Regulation 4.13(b)(1) and an annual filing affirming that the person continues to comply with the conditions in the regulation pursuant to CFTC Regulation 4.13(b)(4).

Until the recent rulemaking, an exempt CPO that relied on CFTC Regulation 4.13 was not barred from relying on an exemption because of any statutory disqualifications in its or its principals’ backgrounds. Rather, the statutory disqualification concept applied solely to registered CPOs.

THE RECENT RULEMAKING

Key Takeaways

  • A CPO will be prohibited from claiming an exemption from registration under CFTC Regulation 4.13 if it or any of its principals has in their backgrounds a statutory disqualification under the CEA.
  • A CPO that currently claims the 4.13(a)(3) de minimis exemption will no longer be able to rely on such exemption if, as of March 1, 2021, it cannot certify that neither it nor any of its principals has in their backgrounds a statutory disqualification.

Statutory Disqualification Representation Requirement

Under the CEA, there are two categories of statutory disqualifications:

  1. Section 8a(2) identifies the more serious disqualifications (providing a hearing as may be appropriate to revoke a person’s registration).
  2. Section 8a(3) identifies less serious disqualifications that may bar a person from registration but only after an opportunity for a hearing.

Section 8a(2) enumerates the offenses pursuant to which the CFTC may—upon notice but without a hearing—refuse to register, register conditionally, or suspend or place restrictions upon the registration of, any person, and for which the CFTC may revoke the registration of any person with such a hearing as may be appropriate.

Under the rule, when a person makes a claim for exemptive relief, the person will be required to represent that neither they nor their principals have in their background a statutory disqualification that would require disclosure under Section 8a(2), unless the disqualification arises from a matter that was disclosed in connection with a previous application for registration and where such registration was granted (applicable to an exempt CPO that operates other commodity pools pursuant to CFTC registration as a CPO). In addition, the person will be required to make this representation each year when affirming its continued compliance with the conditions in CFTC Regulation 4.13.

The final rule differs in only two minor ways from the 2018 proposal:[4]

  1. The final rule does not include an exception from the representation for statutory disqualifications that were “disclosed more than thirty days prior to the claim of th[e] exemption.”
  2. The final rule explicitly limits its scope to Section 8a(2) of the CEA instead of both Sections 8a(2) and 8a(3) of the CEA. Many commenters advocated for a narrower scope, and this should help reduce the compliance burden associated with the final rule.

Exemptive Relief to Be Issued on an Infrequent Basis

If a person or the person’s principals are subject to a statutory disqualification under Section 8a(2) but would like to rely on CFTC Regulation 4.13, the person may seek exemptive relief from the CFTC. Any such request for exemptive relief must include the facts and legal rationale demonstrating that relief (1) would be consistent with the public interest and (2) would not be contrary to the specific purposes of CFTC Regulation 4.13(b)(1).

Although the CFTC notes that it will issue this sort of relief on an infrequent basis, it recognizes that there may be facts and circumstances where allowing a disqualified CPO or principal to operate exempt commodity pools would not be inconsistent with the CFTC’s customer protection concerns.

COMPLIANCE CHECKLIST

A registered CPO that manages some of its commodity pools pursuant to an exemption under CFTC Regulation 4.13 is subject to statutory disqualification notification requirements upon application for registration and at any time after the CPO becomes registered.

As a result, such a registered CPO should have procedures in place for identifying statutory disqualifications and providing notice through the NFA online exemption system. The notification requirement for an exempt CPO does not cover a disqualification arising from a matter that such exempt CPO previously disclosed in connection with an application for CPO registration where such registration was granted.

An exempt CPO that is not registered with the CFTC with respect to the operation of commodity pools will be required to perform an analysis prior to making an exemptive filing and thereafter. To make the new representation, an exempt CPO should engage in a two-step process: (1) Identify the principals of the exempt CPO and (2) confirm that the exempt CPO and its principals are not subject to a statutory disqualification under Section 8a(2) of the CEA.

  1. Who is a principal of the exempt CPO of the commodity pool?
    • Certain persons are principals because of their title or role at the exempt CPO, including a director, president, chief executive officer, chief operating officer, chief financial officer, chief compliance officer, or a person in charge of a business unit, division, or function subject to regulation by the CFTC of a corporation or their corporate control status at the exempt entity.
    • Other persons are principals because of their 10% or greater direct or indirect ownership of the exempt CPO’s equity voting securities, their entitlement to receive at least 10% of the exempt CPO’s net profits, their contribution of 10% or more of capital, or their power to exercise a controlling influence over the exempt CPO’s activities that are subject to regulation by the CFTC.
  2. Is the exempt CPO or any of its principals subject to a statutory disqualification under Section 8a(2)?

Generally, a person is subject to a statutory disqualification under Section 8a(2) if they meet any of the following criteria:

  • Prior registration in any capacity has been suspended (and the period of such suspension has not expired) or has been revoked.
  • Registration in any capacity has been refused under the provisions of Section 8a(3) of the CEA within the preceding five years or at any time thereafter.
  • The person is enjoined from acting as a CFTC or SEC registrant.
  • The person is enjoined from engaging in activity that involves embezzlement; theft; extortion; fraud; fraudulent conversion; misappropriation of funds, securities, or property; forgery; counterfeiting; false pretenses; bribery; gambling; or any transaction in or advice concerning futures contracts, security futures, or securities.
  • The person has been convicted of a specified felony within the preceding 10 years.
  • The person has violated the CEA or a securities statute within the preceding 10 years, where such violation involves embezzlement; theft; extortion; fraud; fraudulent conversion; misappropriation of funds, securities, or property; forgery; counterfeiting; false pretenses; bribery; or gambling.
  • The person is subject to a CFTC order denying exchange or clearinghouse privileges.
  • As to any of the matters set forth in Sections 8a(2) and 8a(3) of the CEA, the person willfully made any materially false or misleading statement or omitted to state any material fact in a registration application.

Before making a representation that a person or the person’s principals are not subject to a statutory disqualification, the person should review Section 8a(2) of the CEA (7 USC § 12a(2)).

WHAT’S NEXT?

Exempt CPOs that currently rely on CFTC Regulation 4.13 have until March 1, 2021 to make the representations regarding their statutory disqualification status through the NFA online exemption system. The CFTC established March 1, 2021 as the effective date for existing exempt CPOs because this date coincides with the annual affirmation required for exempt CPOs that rely on CFTC Regulation 4.13, except for those exempt CPOs that manage family offices. All other persons who determine to make a filing under CFTC Regulation 4.13 and rely on an exemption thereunder (except for persons that manage family offices) will be subject to the representation requirement starting 60 days after the rule is published in the Federal Register.

Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Chicago
Sarah V. Riddell
Michael M. Philipp

New York
Thomas V. D’Ambrosio

Boston
Katherine Dobson Buckley


[1] The CFTC will, however, issue a “special call” to family offices for information regarding whether their CPOs and principals are subject to any statutory disqualifications and consider such information in determining whether to extend the exemption to family offices in the future.

[2] The CEA defines a CPO as any person engaged in a business that is of the nature of a commodity pool, investment trust, syndicate, or similar form of enterprise, and who, with respect to that commodity pool, 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.

[3] Such disqualifications include, among others, if (a) any prior CFTC registration status has been suspended or revoked; (b) registration in any capacity has been denied by the CFTC within the past five years for any reason under CEA section 8a(3); (c) a person has been permanently or temporarily enjoined from acting in various capacities that are regulated by the CFTC or US Securities and Exchange Commission (SEC) or engaging in activity involving crimes such as embezzlement, theft, fraud, or misappropriation; or (d) within the past 10 years a person has been convicted of (i) any felony involving commodities or securities activity or a crime such as embezzlement, theft, fraud, or misappropriation, or (ii) any violation of the commodities or securities laws of the United States (among other federal laws) involving a crime such as embezzlement, theft, fraud, or misappropriation (including aiding or abetting such a crime).

[4] In 2018, the CFTC issued a proposed rule on “Registration and Compliance Requirements for Commodity Pool Operators and Commodity Trading Advisors.” See Federal Register / Vol. 83, No. 202 / Thursday, October 18, 2018 / Proposed Rules.