On May 6, 2013, the United States Court of Appeals for the District of Columbia Circuit heard oral argument in the case brought by the Investment Company Institute and the U.S. Chamber of Commerce (“Appellants”) that challenges amendments to CFTC Regulation 4.5.
In February 2012, the CFTC amended Regulation 4.5, which provides registered investment companies with an exclusion from the definition of commodity pool operator (“CPO”). As amended, Regulation 4.5 limits the amount of exposure to commodity interests – such as commodity futures and options and swaps – that a registered fund may have. As a result, under the amended Regulation, firms are required to conform their investment activities with the requirements of amended Regulation 4.5 or to register as CPOs. (As a technical matter, the CFTC has clarified that the investment adviser to a fund, rather than the fund itself, would register as a CPO if the fund could not avail itself of the exclusion provided by Regulation 4.5.) The CFTC also adopted Regulation 4.27, which imposes reporting requirements on CPOs, including CPOs of registered funds, and it has proposed certain regulations that will apply recordkeeping and disclosure requirements on these registered firms (the “Compliance Rules”).
On April 17, 2012, the ICI and the Chamber filed a complaint in the United States District Court for the District of Columbia that challenged these rule changes. On December 12, 2012, the District Court issued an opinion granting the CFTC’s motion for summary judgment and upholding the amendments. (For a discussion of that decision, please see our earlier alert.) The ICI and the Chamber have appealed that decision and are seeking the reversal of the District Court’s decision.
While we cannot predict the outcome in this case, we think the following points raised during oral argument on May 6 are noteworthy:
• Reversal of 2003 Rulemaking. Appellants argued that amended Regulation 4.5 should be vacated because the CFTC failed to address why it was appropriate to reverse its 2003 version of Regulation 4.5, which contained no investment limits for registered funds claiming the relief. The CFTC responded that its decision to impose limits in the Regulation was justified by the 2007-2008 financial crisis and the repeal by Dodd-Frank of key provisions of the Commodity Futures Modernization Act on which the 2003 version of the Regulation had been based. The CFTC also argued that, as the District Court had observed, the amendments to Regulation 4.5 were intended as prophylactic measures to prevent future problems before they occurred.
• Effect on Market Liquidity. Appellants also noted that effects on liquidity were not addressed in the February 2012 final rule release for amended Regulation 4.5 (“2012 Release”), despite the fact commenters warned that the amendments could have potentially adverse consequences. In particular, Appellants argued that the CFTC did not explain why in 2003 it viewed increased market participation by registered funds as a benefit of removing the then-applicable portfolio limit but, by February 2012, had changed its mind and imposed a limit. The CFTC responded with two arguments. First, it explained that Appellants’ liquidity argument relied solely on comments that the Compliance Rules would reduce registered funds’ derivatives-market participation. The CFTC explained that it had addressed those comments by having issued a separate proposal addressing how the Compliance Rules would apply to registered fund CPOs in light of the current requirements applicable to registered funds under the Investment Company Act of 1940. The CFTC noted that it had also deferred the requirement for registered fund CPOs to file reports under Regulation 4.27 until the CFTC could issue final Compliance Rules. Second, the CFTC stated that one reason for amending Regulation 4.5 was to aid the CFTC in understanding better the extent to which registered funds are a source of liquidity – i.e., by requiring the funds' CPOs to report certain data concerning trading in the markets for CFTC regulated products.
• Overlap with Existing SEC Regulations for Registered Funds. Appellants argued that existing requirements under the Investment Company Act already provide certain “significant benefits” cited by the CFTC in the 2012 Release - i.e., promoting fitness and competency of registered entities and providing a means of addressing wrongdoing by market participants. Appellants explained that the 2012 Release did not discuss the adequacy of existing SEC regulations in providing those benefits. The CFTC responded by arguing that Appellants failed to consider that the two agencies have different jobs and that, to the extent that regulations overlapped between the two entities, the CFTC had proposed amendments to its Compliance Rules that it believed would harmonize requirements under both regimes. The CFTC also noted it had jurisdiction over the markets for certain instruments - like commodity futures, commodity options, and most swaps - that the SEC lacked.
• Cost-Benefit Analysis. Appellants argued that the CFTC failed to comply with the cost-benefit analysis requirements of the Administrative Procedure Act and the Commodity Exchange Act. On this basis, they urged the Court of Appeals to follow its recent decisions vacating SEC regulations where it found that the SEC had failed to adequately consider the adequacy of existing regulation as part of its cost-benefit analysis required by law. The CFTC responded that it was obligated under the Commodity Exchange Act to consider the costs of the amended Regulation and, by assessing the membership and application fees and time spent on application for registration, it had done so. The CFTC also noted that it had tried to reduce the burdens of registration by creating different thresholds that would require entities to fill out only certain parts of the periodic reports required under Regulation 4.27 (i.e., reports on new Form CPO-PQR).
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The forthcoming decision by the Court of Appeals will be a significant one for the registered funds industry. Many fund sponsors have registered as CPOs and, if they must remain so registered once a decision in this matter is reached, will be required to comply with the final Compliance Rules and to report under Regulation 4.27.
It should be noted, however, that the Court of Appeals is not considering whether to vacate CFTC Regulation 4.13(a)(3), which imposes substantially similar limits on private funds as those found in amended Regulation 4.5. Many registered funds have established wholly-owned controlled foreign corporations in order to trade certain commodity interests. The CFTC has explained that those subsidiary funds may not piggyback on the exclusion provided by Regulation 4.5 to their parent investment companies. As a result, several registered fund sponsors have registered (or have had affiliates register) as CPOs with respect to controlled foreign corporations. Absent some change in the CFTC’s position or further amended regulations, those sponsors (or their affiliates) will likely need to remain registered as CPOs if their funds’ controlled foreign corporations continue to invest in commodity interests above the limits in Regulation 4.13(a)(3). In this sense, there is some chance that a victory for the ICI and the Chamber in the Court of Appeals may not be a complete one for the industry.
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:Copenhefer-Lea-Anne
This article was originally published by Bingham McCutchen LLP.