In February 2012, the CFTC adopted final amendments to its rules governing commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”). Among other things, the CFTC determined to rescind Rule 4.13(a)(4) of its regulations, an exemption from CPO registration upon which many sponsors of private funds have relied.
This rule change has caused Hong Kong-based investment management companies to evaluate whether they must register with the CFTC or whether they can rely on an available exemption from CPO/CTA registration. This alert provides a brief refresher on CPO/CTA status and then discusses potential registration options that are available to a Hong Kong manager that provides investment management services to offshore funds pursuant to delegation arrangements with related Cayman Islands exempted fund management companies.
This alert assumes that the Hong Kong manager and the Cayman management company, as well as any general partner of an offshore fund, will be required to register with the CFTC. Except where noted, therefore, this alert does not address whether any exemptions may be available to these firms.
How are “Commodity Pool Operator” and “Commodity Trading Advisor” Defined?
A commodity pool operator is any person engaged in the business of sponsoring a fund (commodity pool) that trades in commodity interests. A commodity trading advisor is any person that, for compensation or profit, engages in the business of advising others about trading commodity interests. For these purposes, commodity interests include: commodity futures and options, security futures products, swaps, leverage transactions, and retail forex and commodity transactions as further defined in the Commodity Exchange Act. The CPO and CTA definitions also include persons that, for whatever reason, register as such with the CFTC.1
Absent an available exemption or exclusion, a firm that falls within the definition of CPO or CTA must register as such with the CFTC.
What Individuals Will Get Caught Up in the CFTC Registration Process?
As explained in our CFTC Registration and Compliance Outline, individuals who are “associated persons” of a registered CPO or CTA must themselves register with the CFTC. This process will generally involve taking and passing the Series 3 exam. In addition, individuals who are “principals” of a firm must make certain filings in connection with their firm’s registration. Both principals and associated persons must submit their fingerprints, and they are subject to criminal background checks as part of this process.
How Might the CPO/CTA Definitions Apply to a Hong Kong Manager?
It is common for a Cayman management company, which typically holds management shares in the offshore funds to which it provides management services, to have an agreement with a Hong Kong manager under which the Hong Kong manager will provide investment management services in respect of those funds. In this structure, a decision will need to be reached about whether to register the Cayman management company as a CPO and the Hong Kong manager as a CTA, a CPO, or both.
In addition, offshore funds structured as limited partnerships have general partners that may delegate investment management functions to a Cayman management company. In turn, the Cayman management company may delegate to a Hong Kong manager responsibility for providing investment management services to those funds. Hong Kong managers using this structure will also have to consider whether the general partner should register as a CPO, along with whether the Cayman management company and the Hong Kong manager should register with the CFTC as a CPO or a CTA.
The CFTC staff has taken the position to date that, with regard to U.S. fund structures, the general partner or managing member of a commodity pool is the pool’s CPO and must register as such or rely on available exemption.2 (These structures differ from those used by Asia-based managers.) This position is broadly consistent with the CPO definition. Based on this guidance, a Cayman management company and a general partner would be required to register as the CPO of the relevant offshore funds. The Hong Kong manager, which provides management services to the funds under an agreement with the Cayman management company, would register as a CTA.
This approach may not line up entirely with the purposes intended by the CFTC’s regulatory regime, however. Neither a Cayman management company nor a general partner typically has operations or staff, and the Hong Kong manager – under delegated authority – usually performs the day-to-day management functions on behalf of the Cayman management company or the general partner. In substance, therefore, the Hong Kong manager may actually function as both a CPO and a CTA. Accordingly, an asset management firm may wish to register both its Hong Kong manager and its Cayman management company as CPOs.
The Hong Kong manager and the Cayman management company may also be required to register separately as CTAs if they enter into agreements or act under delegated authority to provide commodity interest trading advice to separate accounts or by providing sub-advisory services.3 Bear in mind that, as noted above, “commodity interest” is a very broad term for these purposes.
Is It Possible for a Hong Kong Manager to Register as a CPO Instead of its Related Cayman Management Company or a General Partner?
It may be possible for a Hong Kong manager to seek to register as a CPO instead of its related Cayman management company or a general partner. While this approach is inconsistent with the general position of the CFTC discussed above, the CFTC staff has allowed individual firms to register a management company in lieu of a managing member or general partner. In order to do so, each of these firms had to submit a written request for no-action relief. The CFTC staff granted this relief subject to a number of conditions including, in relevant part, a requirement that the firm provide a written acknowledgment that the adviser (registered as a CPO) and the general partner/managing member (not so registered) would be jointly and severally liable for any violations of the Commodity Exchange Act. We also understand that the CFTC staff would expect the adviser serving as the CPO to be authorized formally by the fund to act in that capacity, rather than solely pursuant to a delegation of authority by the general partner/managing member.
It should be noted that the CFTC staff typically grants no-action relief only with respect to proposed activities, rather than activities that are ongoing.4 This requirement may not preclude the CFTC staff from considering relief for Hong Kong managers and their Cayman companies and general partners, given that these entities were able to operate without CFTC registration for years under an exemption that the CFTC only rescinded in February 2012. However, there is a separate concern that the CFTC staff may not be amenable at present to granting relief that – in its view – could allow entities such as Cayman companies or general partners to conduct activities that would otherwise require registration.
Hong Kong managers, Cayman management companies and general partners should bear in mind that they must have the appropriate registrations in place by December 31, 2012.5 Applying for no-action relief takes time, and the CFTC may not respond to a firm’s request for several weeks. As a practical matter, therefore, these firms may not be able to meet the registration deadline if they delay their applications pending a response from the CFTC staff and ultimately do not receive the requested no-action relief.
If a Cayman Management Company or a General Partner Registers as a CPO, Can the Related Hong Kong Manager Avoid Registration as a CTA?
The Commodity Exchange Act provides an exemption from CTA registration for any firm that, during the prior 12 months, has not provided commodity interest trading advice to more than 15 persons and that does not hold itself out generally to the public as a CTA.6 If a Hong Kong manager only offers advice pursuant to agreements with one or more affiliated Cayman management companies or general partners to privately offered funds, it may be possible for the Hong Kong manager to argue that it is eligible to rely on this exemption.
This approach could raise significant concerns for the CFTC, however. In short, it would result in Cayman management companies and general partners – which typically have no operations or staff – being the only entities subject to direct CFTC oversight within an asset management organization. Meanwhile, the entity that actually performs the management activities in which the CFTC has a regulatory interest would remain unregistered. Generally speaking, U.S. regulators like the CFTC frown upon arrangements that they believe elevate form over substance. It therefore may not be prudent for Hong Kong managers to seek to rely on an exemption from CTA registration in these or similar circumstances.
How Will Directors of Cayman Management Companies and General Partners Be Affected by CPO Registration?
The directors of a Cayman management company or a general partner registering as a CPO would be considered principals of the firm, and at least one director would have to pass the Series 3 exam and register as an associated person of the firm. Since at least one representative of a Hong Kong manager is likely to serve on the board of directors of a Cayman management company and (as applicable) each general partner, it may be possible for that person to register as an associated person of the Cayman management company and a general partner rather than any of the other directors. This approach assumes that those other directors are not involved in soliciting fund investors or supervising others who are involved in those solicitations. All directors of a Cayman management company or a general partner would however be principals and thus would be subject to fingerprinting and other requirements, even if they are not deemed associated persons of those entities.
To Sum Up, What Are the Main Options for CPO/CTA Registration?
The answer to this question will depend largely on the specific facts pertaining to the particular Hong Kong manager, Cayman management company, or general partner. But, in general, we think there are two main approaches to CFTC registration that firms involved in operating and advising offshore funds may wish to explore:
Of course, firms may want to consider what approach to take based not only on CFTC requirements and guidance but also in light of the business considerations that caused them to create separate management and advisory entities within their organizations. Those considerations typically include Hong Kong profits tax and transfer pricing issues and the licensing status of the Hong Kong manager. It is advisable for Hong Kong managers to seek specific Hong Kong tax and regulatory advice on these issues before determining in which capacities they will register with the CFTC. Firms should also consider whether certain exemptions from CPO/CTA registration may apply to specific parts of their businesses.
This alert only addresses a few specific questions for Hong Kong-based asset management firms. We have prepared other resource materials that go into further detail on CFTC requirements applicable to CPOs and CTAs, which firms may wish to consult for further background information:
* * * * *
Please feel free to reach out to your regular contacts at the Firm if you have any questions about the matters addressed in this alert. In addition, you are welcome to contact any of the above members of the Firm’s CFTC Working Group.
1 The definitions of CTA and CPO may be found in the Commodity Exchange Act and the CFTC’s rules thereunder. See 7 U.S.C. §§ 1a(11), (12), 17 C.F.R. §§ 1.3(bb)(1), (cc). We also discuss these definitions in our CFTC Registration and Compliance Outline.
2 See, e.g., CFTC Letter No. 98-20 (Mar. 24, 1998), CFTC Letter No. 75-16 (Oct. 15, 1976).
3 A registered CPO has an automatic exemption from CTA registration as to the pools for which it serves and is registered as a CPO. See 17 C.F.R. § 4.14(a)(4).
4 See generally 17 C.F.R. § 140.99 (requirements for requesting exemptive, no-action, and interpretative letters).
5 On July 13, 2012, the CFTC issued a letter permitting firms to claim no-action relief from the CPO and CTA registration requirements with respect to funds launched after that date. This relief is effective until December 31, 2012. In essence, this letter allows those firms to engage in activities that would otherwise require CFTC registration, provided that they are registered in the appropriate capacities as to those funds by December 31, 2012. See CFTC Letter No. 12-03 (July 13, 2012).
6 See 17 U.S.C. § 6m(1). The CFTC has specified by rule that, for this purpose, a firm would not be considered as holding itself out generally to the public as a CTA solely because it participates in a non-public offering of securities by a fund, pursuant to an exemption from registration of the fund’s share offering under the U.S. Securities Act of 1933. See 17 C.F.R. § 4.14(a)(10)(iii).
This article was originally published by Bingham McCutchen LLP.