The CFTC is going to dramatically expand its realm through the one-two punch of gaining regulatory control over non-securities derivatives and the removal of a widely used exemption. (With the release of REITs from the definition of “commodity pool” perhaps the CFTC is loosening its grip.) Fortunately, there is another exemption that most private equity funds will be able to utilize. But it requires some math.
CFTC Regulation 4.13(a)(3) contains a “De Minimis Exemption.” To take advantage of the exemption a fund must satisfy these requirements:
- The Funds is exempt from registration under the Securities Act of 1933 and offered without marketing to the public in the U.S.
- The CPO has a reasonable belief that investors are “accredited investors”, “knowledgeable employees” or “qualified eligible persons”.
- The fund discloses to each prospective investor in the Commodity Pool that the CPO is exempt from registration under the De Minimis Exemption and therefore, unlike a registered CPO, is not required to deliver a disclosure document or a certified annual report to investors.
- File an initial notice of claim with the National Futures Association, and renew on an annual basis.
- One of two trading tests must be met:
- 5% cost: the aggregate initial margin, premiums, and required minimum security deposit for retail forex transactions required to establish commodity interest positions (including securities futures positions), determined at the time the most recent position was established, will not exceed 5 percent of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into; or
- 100% value: the aggregate net notional value of such positions, determined at the time the most recent position was established, does not exceed 100 percent of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into.
What’s not clear to me is how portfolio companies and subsidiaries fit into the tests. I assume you would treat a wholly-owned subsidiary as you would treat fund -level activity. At some point the fund’s ownership in an entity should remove it from being part of the fund level calculation. I just have not dived deep enough into the CFTC world to figure out where that threshold is.
For private equity funds and real estate funds, the 100% test may be close depending on the type of leverage used and the risk mitigation used. However, the 5% cost should be easy. Interest rate swaps and foreign exchange hedge are usually very cheap, less than 5% of the nominal value of the hedge.