The CFTC stretched when it said that a fund entering into even a single swap used purely for hedging purposes — will hold “commodity interests” and accordingly could be viewed as commodity pools by the CFTC. The CFTC has construed the concept of commodity pool broadly and has consistently maintained that there is no minimum trading threshold for qualification as a CPO.
The big complication is that interest rate derivatives are now considered commodity interests and subject to CFTC oversight. Up until a few weeks ago, foreign exchange derivatives were also considered a commodity interest. On November 16, 2012, the US Department of the Treasury issued a final determination that foreign exchange swaps and certain foreign exchange forwards are not commodity interests.
In looking closer at the statutory definition of “commodity pool” it seems that single swap should not turn a private fund into a commodity pool.
Title 7 of the US Code Section 1(a)
(10) Commodity pool
(A) In general
The term ‘‘commodity pool’’ means any investment trust, syndicate, or similar form of enterprise operated for the purpose of trading in commodity interests, including any—
(i) commodity for future delivery, security futures product, or swap;
(ii) agreement, contract, or transaction described in section 2(c)(2)(C)(i) of this title or section 2(c)(2)(D)(i) of this title;
(iii) commodity option authorized under section 6c of this title; or
(iv) leverage transaction authorized under section 23 of this title.
From the statutory definition, the fund needs to operated for the purpose of trading in commodity interests.
One argument is that the fund is an end user and therefore not organized for the “purpose of trading in commodity interests.” Under the new end user exception to the swap clearing requirement, the key test is whether the entity is “using the swap to hedge or mitigate commercial risk.”
What is a swap used to hedge or mitigate commercial risk?
(c) Hedging or mitigating commercial risk.
For purposes of section 2(h)(7)(A)(ii) of the Act and paragraph (b)(1)(iii)(B) of this section, a swap is used to hedge or mitigate commercial risk if:
(1) Such swap:
(i) Is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, where the risks arise from:
(A) The potential change in the value of assets that a person owns, produces, manufactures, processes, or merchandises or reasonably anticipates owning, producing, manufacturing, processing, or merchandising in the ordinary course of business of the enterprise;
(B) The potential change in the value of liabilities that a person has incurred or reasonably anticipates incurring in the ordinary course of business of the enterprise;
(C) The potential change in the value of services that a person provides, purchases, or reasonably anticipates providing or purchasing in the ordinary course of business of the enterprise;
(D) The potential change in the value of assets, services, inputs, products, or commodities that a person owns, produces, manufactures, processes, merchandises, leases, or sells, or reasonably anticipates owning, producing, manufacturing, processing, merchandising, leasing, or selling in the ordinary course of business of the enterprise;
(E) Any potential change in value related to any of the foregoing arising from interest, currency, or foreign exchange rate movements associated with such assets, liabilities, services, inputs, products, or commodities; or
(F) Any fluctuation in interest, currency, or foreign exchange rate exposures arising from a person’s current or anticipated assets or liabilities; or
(ii) Qualifies as bona fide hedging for purposes of an exemption from position limits under the Act; or
(iii) Qualifies for hedging treatment under:
(A) Financial Accounting Standards Board Accounting Standards Codification Topic 815, Derivatives and Hedging (formerly known as Statement No. 133); or
(B) Governmental Accounting Standards Board Statement Accounting and Financial Reporting for Derivative Instruments; and
(2) Such swap is:
(i) Not used for a purpose that is in the nature of speculation, investing, or trading; and
(ii) Not used to hedge or mitigate the risk of another swap or security-based swap position, unless that other position itself is used to hedge or mitigate commercial risk as defined by this rule or Sec. 240.3a67-4 of this title.
I think most private equity funds and real estate private equity funds would be using interest rate derivatives to hedge or mitigate commercial risk.
The tough part of this argument is that a “financial entity” is not an end user.
2(h)(7)(C)(i)‘‘financial entity’’ means—
(I) a swap dealer;
(II) a security-based swap dealer;
(III) a major swap participant;
(IV) a major security-based swap participant;
(V) a commodity pool;
(VI) a private fund as defined in section 80b–2(a) of title 15;
(VII) an employee benefit plan as defined in paragraphs (3) and (32) of section 1002 of title 29;
(VIII) a person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 1843(k) of title 12.
In case you have forgotten about the definition of private fund under Dodd-Frank:
The term “private fund” means an issuer that would be an investment company, as defined in section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a–3), but for section 3(c)(1) or 3(c)(7) of that Act.
The end user exemption excludes private funds. That seems bad and is going to kick all of the newly registered private equity and real estate private equity funds out of the end-user exemption.
On top of that, there is a de minimis exemption from registration 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.
That still leaves me stuck with trying to figure out when an entity becomes a commodity pool. The regulations provide no further guidance. One case that addresses the definition is Lopez v. Dean Witter Reynolds 805 F.2d 880 1986. Unfortunately for my purposes it focuses on whether separate accounts are aggregated enough to be a pool.
In CFTC v. Heritage Capital Advisory Services, Ltd. (Comm. FUT. L. REP. (CCH) 21,627, 26,377 (N.D. Ill. 1982).) the ruled that a fund investing in Treasuries and hedging the risk was a commodity pool. The defendants had solicited and pooled public funds with the stated intention of investing approximately 97% of the proceeds in United States Treasury bills, and using the remainder to hedge the account by trading futures contracts on Treasury bills. The ruling concluded that “[t]he risk to the funds of the defendants’ investors far exceeded the 3% discount which was supposedly to be committed to the futures markets” because of the possibility of a rapid decrease in the applicable market or of the pool being required to take delivery of costly Treasury bills pursuant to a future contract.
That does not provide much help for private equity funds and real estate private equity funds.