Expiring CFTC Relief May Trigger Review of CFTC Exempt Status for Fund Managers

In December 2012, the staff of the U.S. Commodity Futures Trading Commission (the “CFTC”) issued temporary relief that, among other things, permitted firms to exclude compo equity total return swaps (“Compo TRS”) from their assessments of whether they must register with the CFTC in some capacity.

On this basis, fund managers have been able to exclude Compo TRS when considering whether they satisfy the portfolio tests imposed by the “de minimis” exemption from registration with the CFTC as commodity pool operators (“CPOs”). This relief will expire on July 1, 2013. As a result, fund managers that are currently relying on the de minimis exemption, which may be found at CFTC Regulation 4.13(a)(3) as to private funds and CFTC Regulation 4.5 as to registered funds, will need to begin including Compo TRS in their calculations by that date in order to determine whether they may continue to claim that exemption.¹

Summary of the De Minimis Exemption

Under CFTC Regulation 4.13(a)(3), a firm is exempt from registration with the CFTC as a CPO with respect to a privately offered fund if the fund engages in limited trading of commodity interests. Substantially similar tests apply under Regulation 4.5 for investment companies registered under the U.S. Investment Company Act of 1940. For this purpose, the term “commodity interest” includes a variety of instruments such as commodity futures and options, certain foreign exchange instruments, and swaps.

Under the exemption, a fund must satisfy at least one of the following limits at all times, with the limit to be tested each time a fund puts on a new trade:

• Initial Margin Limit. The aggregate initial margin, premiums, and required minimum security deposit for retail forex transactions required to establish the fund’s positions in commodity interests (determined at the time the most recent position was established) must not exceed 5 percent of the liquidation value of the fund’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into.²
• Aggregate Net Notional Value Limit. The aggregate net notional value of a fund’s positions in commodity interests, determined at the time the most recent position was established, must not exceed 100 percent of the liquidation value of the fund’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into.³

Compo TRS would be caught within these calculations since they contain both equity and foreign exchange elements — i.e., they would be considered “mixed swaps,” which is a category of instruments subject to regulation as “swaps” by the CFTC and as “security-based swaps” by the US Securities and Exchange Commission (the “SEC”). The CFTC staff’s letter provides, however, that firms could choose not to treat Compo TRS as swaps (more specifically, as “mixed swaps”) and thus not as commodity interests for this purpose until July 1, 2013.

Comparison of Compo TRS and Quanto Equity Swap Categories

In a Compo TRS, “the parties assume exposure to, and the total return is calculated based on, both the performance of specified foreign stocks and the change in the relevant exchange rate.”⁴ In the view of the regulators, therefore, a Compo TRS is a mixed swap and, as such, is a type of swap for purposes of the CFTC’s regulations.

By contrast, the regulators have explained that a quanto equity swap is considered a security-based swap and thus not subject to the CFTC’s jurisdiction if:

Since currency exposure in a Compo TRS can be avoided “by entering into a quanto equity swap, the currency exposure obtained” with a Compo TRS is “not incidental to the equity exposure.”⁶ It is this difference that, under the regulators' interpretation, makes Compo TRS mixed swaps subject to joint CFTC and SEC jurisdiction.

The CFTC staff’s letter provides only a temporary reprieve from this interpretation. As a result, firms with funds that trade Compo TRS will now need to consider their status under CFTC regulations — including the de minimis exemption — in light of their funds’ positions in those instruments.⁷

Potential Next Steps

In light of this pending development, firms that currently rely on the de minimis exemption should confirm whether they are including Compo TRS in their portfolio tests. If not, they should consider doing so ahead of the July 1, 2013 deadline. Depending upon the results of this analysis, fund managers may wish to consider a variety of potential next steps.

For a fund that breaches both tests when Compo TRS are included, a manager could consider rebalancing the fund’s portfolio in a manner that would allow its commodity interest exposure to satisfy at least one of the portfolio tests under the de minimis exemption prior to July 1, 2013. This could be achieved by reducing commodity interest positions or increasing the fund’s exposure to non-commodity interest positions. A manager could also consider placing a moratorium on making further commodity interest trades until one of the tests could be satisfied, because the tests only apply when a new commodity interest position is established. In considering such measures, however, a fund manger may wish to evaluate whether changing a fund’s asset mix or placing a moratorium on trading would be consistent with the fund’s investment objectives and strategies, as well as the manager’s overall responsibility to act in the best interests of the fund and its investors.

If a manager ultimately determines that reliance on the de minimis exemption is no longer possible, it should seek to register as a CPO as quickly as possible in light of the July 1, 2013 deadline. In this connection, the firm may need to consider some of the measures noted above on a short-term basis while the firm’s registration is pending — i.e., to the extent the firm would fail to satisfy either test under the de minimis exemption after July 1, 2013.

Looking beyond that date, firms may wish to consider whether they would be able to achieve desired investment exposures for their funds by trading instruments that, unlike Compo TRS, will not raise the prospect of CPO registration. Of course, any possible alternative investments would need to be evaluated in light of the investment objectives and strategies of the relevant fund and the relative availability of other suitable investment opportunities. In this regard, it is also worth noting that CPO registration would provide a fund manager with greater flexibility to invest fund assets than if the manger were instead to continue seeking to rely on the de minimis exemption.

Finally, firms should consider the extent to which they will be required to comply with other CFTC regulations with respect to Compo TRS after July 1, 2013. Under the Dodd-Frank financial reform law, swaps are subject to comprehensive recordkeeping and reporting provisions, among other requirements. In addition, the counterparties trading these instruments with funds may be CFTC-registered swap dealers, in which case further Dodd-Frank requirements applicable to the dealers may affect the funds’ trading documentation and account relationships. Fund managers will need to consider these requirements separately from the question of whether they can continue to rely on the de minimis exemption from CPO registration with respect to funds that trade Compo TRS.

¹ The CFTC staff’s letter can be found at: http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/12-64.pdf.

² In the case of an option that is in-the-money at the time of purchase, the in-the-money amount, as defined in CFTC Regulation 190.01(x), may be excluded in computing the 5 percent limitation.

³ “Notional value” is calculated for each futures position by multiplying the number of contracts by the size of the contract in contract units (taking into account any multiplier specified in the contract), then multiplying that number by the current market price per unit; for each option position by multiplying the number of contracts by the size of the contract, adjusted by its delta, in contract units (taking into account any multiplier specified in the contract), and then multiplying that number by the strike price per unit; for each retail forex transaction, by calculating the value in U.S. Dollars of such transaction, at the time the transaction was established, excluding for this purpose the value in U.S. Dollars of offsetting long and short transactions, if any; and for any cleared swap by the value as determined consistent with the terms of Part 45 of the CFTC Rules.  Futures contracts with the same underlying commodity across designated contract markets and foreign boards of trade; and swaps cleared on the same designated clearing organization may be netted where appropriate.

⁴ 77 Fed. Reg. 48208, 48265 (Aug. 13, 2012).

⁵ Id.

⁶ Id.

⁷ Treatment of Compo TRS as CFTC-regulated swaps could raise questions about other categories of CFTC registration as well, including possible registration as a commodity trading advisor for the investment advisor to a separate account or a fund.