The first question is what is a CPO and why should I care? The Commodities and Futures Trading Commission decided to tighten the exemptions from registration potentially pulling some hedge funds and private equity funds that previously ignored the CFTC. Davis Polk held a webinar on this topic. Some private fund managers may get the CPO label and have to deal with the CFTC regulatory regime.
CPO is the CFTC acronym for “Commodity Pool Operator”, which refers to any person engaged in the business of soliciting investors for an investment trust operated for the purpose of trading in commodity interests.
- Commodity interests include futures (including agricultural, metal and financial futures), commodity options and, upon the issuance of final rules under Dodd-Frank, swaps.
- Swaps include a wide variety of transactions, including interest rate swaps, many types of currency swaps, energy and metal swaps, agricultural swaps, commodity swaps, swaps on broad-based indices, and swaps on government securities.
The CFTC has long expressed the view that transacting in any amount of futures contracts (either directly or indirectly) would cause a fund sponsor to be deemed a commodity pool operator. There is no de minimis exception in the definition. So the CFTC position results in the conclusion that fund sponsors who have interest rate swaps or foreign exchange swaps will likely be deemed to be commodity pool operators and will need to evaluate whether an exemption is available. Even a funds of funds may also be deemed to be commodity pools depending on the investment activities of underlying funds.
There used to be a broad exemption. CFTC Rule 4.13(a)(4) provides a blanket exemption from CPO registration for sophisticated investor funds (i.e., those offered to Qualified Purchasers). The CFTC has decided to rescind this exemption.
A private fund sponsor will be required to register unless each of its funds satisfies the de minimis trading limitations under the terms of Rule 4.13(a)(3). Under these requirements, either:
- Initial margin and premiums for commodity interest transactions must be less than 5% of the liquidation value of the fund; or
- Aggregate net notional value of commodity interest transactions must be less than 100% of the liquidation value of the fund.
In addition to those de minimis trading requirement, Rule 4.13(a)(3) is available so long as:
- the fund is offered privately to certain types of investors; and
- the fund is not marketed as a vehicle for trading in the commodity futures or commodity options markets.
Investors in a Rule 4.13(a)(3) vehicle may include, among others:
- any accredited investors under Reg D; and
- knowledgeable employees as defined under Rule 3c-5 under the 1940 Act and certain other employees.
Most private equity and real estate private equity fund should be able to meet these hurdles and can focus on the 5% margin test and the 100% net notional exposure test.
5% margin test: The aggregate initial margin and premiums for commodity interest transactions (and minimum security deposits for retail forex transactions) must be less than 5% of liquidation value of the fund (including unrealized profits and losses to date).
100% net notional exposure test: The aggregate net notional value of commodity interest positions must not exceed 100% of the liquidation value of the fund.
- Notional value is defined by asset class.
- Futures contracts are valued by multiplying the number of contracts by the size of the contract.
- Futures options are based on the strike price per unit and adjusted by the option’s delta.
- Futures contracts with the same underlying commodity may be netted across markets.
- Notional value of swaps cleared by the same DCO may be netted, “where appropriate”.
The 5% margin test or 100% net notional exposure tests are required to be met at each time that a commodity position is established.
The CFTC has requested comments during the 60-day period beginning on Friday, February 11, 2011. If the proposed rule is adopted, the CFTC will issue a final rule that will specify when hedge fund and other private fund managers relying on CFTC Rules 4.13(a)(3) and 4.13(a)(4) will need to revise or cease their commodity interest trading or register as CPOs (and, if applicable, CTAs) and become members of the NFA.
The text of the proposed rule can be found here: http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2011-2437a.pdf