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  Regulatory Roundup Autumn 2010

Regulatory Roundup Summer 2010

By Felix Shipkevich, General Counsel, CMS Forex

United States

The United States has long been one of the leading markets for commodity investments, with approximately $800 billion under management in funds investing in commodities. In the United States, private funds that invest in futures contracts are referred to as "commodity pools" under the Commodity Exchange Act (CEA). While the CEA governs commodity pools, it does not regulate them directly. Instead, it imposes requirements on the commodity pool operator (CPO), monitored by the Commodity Futures Trading Commission (CFTC). It should be noted that the CFTC originally considered a fund to be a commodity pool so long as it engaged to any significant extent in the futures market, even if the fund invested primarily in securities. However, recent CFTC amendments exclude operators of entities that are registered with the Securities and Exchange Commission (SEC) from the definition of CPOs, and remove any trading or marketing limitations on those entities. These entities must disclose to participants that they have claimed this exclusion, and that they are not subject to the CEA. In order to facilitate the CFTCs regulatory functions, the CEA requires CPOs to register with the CFTC, and then comply with specific disclosure, reporting, and record keeping requirements.

A fund registers with the CFTC by filing a Form 7-R for the CPO entity and a Form 8-R for each principal and associated person of the CPO. Under CFTC Rules 4.21(a) and 4.31(a), a registered CPO can solicit clients prior to providing a disclosure document, provided that the disclosure document is delivered no later than the subscription agreement for a pool, and any information provided prior to the delivery of the disclosure document is either consistent with, or amended by, the information in the disclosure document. However, a copy of the disclosure document must be filed with the National Futures Association (NFA) at least 21 days prior to providing it to prospective investors. This disclosure document must then be updated every nine months. Once the pool is up and running, the CPO must also provide any future prospective investors with the fund's annual report, as well as the fund's most recent account statement or its performance information for the past 60 days.

Aside from these registration and solicitation rules, there are rules in place for periodic reporting to investors. The registered CPO must distribute to investors monthly or quarterly account statements, as well as an annual report. The NFA also requires registered CPOs to deliver to it electronic reports each quarter, outlining operations and performance data. To discourage fraud, the CFTC also requires CPOs to maintain detailed books and records concerning itself and the fund at its main business headquarters. For example, the CPO must retain itemized daily records of each commodity interest transaction, at both the CPO and fund level.

There are exemptions from these registration and reporting requirements, however. The first is the previously mentioned exemption for operators of otherwise regulated entities registered with the SEC, regulated insurance companies, banks, and pension plans. In 2003, the CFTC also adopted two exemptions for non-regulated entities. The first is the de minimis exemption, CFTC Rule 4.13(a)(3), which exempts from registration CPOs made up of permitted investors, that trade only a minimal amount of futures. The second is the sophisticated investor exemption, CFTC Rule 4.13(a)(4), which exempts from registration CPOs in which all investors are Qualified Eligible Persons (QEPs) and Accredited Investors. The de minimis and sophisiticated investor exemptions are claimed by filing a notice with the NFA.

The de minimis exemption focuses on CPOs that are focused primarily on securities, and only engage in futures trading to a limited extent. To qualify, each investor must be either:

1. an accredited investor, per Regulation D of the Securities Act of 1933;
2. a family trust formed by an accredited investor;
3. a knowledgeable employee, per the Investment Company Act of 1940; or
4. a QEP, per CFTC Rule 4.7(a)(2)(viii)(A).

Further, trading is limited so that either:

1. required initial margin and premiums for futures do not exceed 5% of the pool's liquidation value, after taking into account unrealized profits and losses on open positions; or
2. the aggregate net notional value of the pool's futures does not exceed 100% of the pool's liquidation value, after taking into account unrealized profits and losses on open positions.

As for fund of funds, the exemption will be available for a fund of fund that:

1. does not trade commodity interests directly, and has no more than 50% of assets allocated to underlying funds that trade commodity interests;
2. directly trades commodity interests in addition to its allocation to underlying funds, so long as the assets traded directly are treated as a separate pool, and the separate pool meets all of the requirements listed above;
3. only invests in funds that claim the de minimis exemption, or funds that are registered and comply with the trading restrictions listed in the de minimis exemption; or
4. has actual knowledge of the commodity interests of the underlying funds, and aggregates the commodity interests to determine compliance with the de minimis exemption. A CPO that qualifies for the de minimis exemption cannot market itself to investors as a vehicle for trading in futures.

The sophisticated investor exemption narrows its focus to CPOs where all of the investors are either accredited investors or QEPs. For individual investors, the individual must be a QEP; however, the individual does not have to meet the portfolio requirements to be considered a QEP. For an entity investor, the entity can be either an accredited investor or a QEP. The trading and marketing limits imposed by the de minimis exemption do not apply to the sophisticated investor exemption.

However, there are still compliance issues regarding CPOs exempted by either the de minimis or the sophisticated investor exemption. First, the pools must be exempt from the Securities Act of 1933 to qualify, and must not be offered to the public. Second, the CPO must provide to the pool participants disclosure of its exempt status, as well as the criteria behind that exemption. If the pool already exists and wants to claim the exemption, it must notify each pool participant of both its intent to withdraw from registration, and the right to redeem the participant's interest prior to the filing for exemption. Third, the CPO must maintain its records for five years, and, if called for by the CFTC, must demonstrate its eligibility for exemption through these records. Finally, the CPO must present any annual reports in accordance with GAAP rules, and any certification by an independent public accountant must be done in accordance with CFTC rules.

A prospective fund manager should be aware that the CFTC has broad jurisdiction and authority to investigate and take action against CPOs that violate these regulations. Both registered and unregistered CPOs are under its purview. Between the years of 2000 and 2008, the CFTC filed 73 enforcement actions concerning CPOs, and had more than 50 open and pending investigations. CFTC disciplinary actions in the past have included: freezing assets, revoking registration for registered pools, entering cease and desist orders, suspending trading, seeking restitution on behalf of clients, and entering civil penalties against both the firm and the individual.

United Kingdom

With the United Kingdom accounting for over a third of the global OTC derivatives market activity in 2007, it is a natural fit for many currency fund managers. Unlike in the United States, where the SEC and CFTC split jurisdiction over investments based on their type, the Financial Services Authority (FSA), regulates the entire financial services industry in the UK. However, by 2012, the FSA will be split into the Consumer Protection and Marketing Authority, which will police the banking system, and the Prudential Regulatory Authority, which will regulate financial firms.

Rising from the ashes of a series of scandals rocking the industry in the '80s and '90s, the FSA has of late become more aggressive than its predecessors in enforcement actions.

However, as most alternative investment funds operating in the UK are not based there, due to favorable tax treatment in nearby locales, a lot of the FSA's regulatory functions focus on the counterparties transacting with them. That being said, the FSA does have a number of regulations in place for consumer protection, limiting risk, and market conduct. It is important to note though, that unlike in the US, where the CFTC rules are largely prescriptive, the FSA rules are largely principle-based. Also, fines are tied to firm revenue and individual salary and benefits, under the new framework implemented in March of 2010.

The term "commodity pool operator" is not widely used in the UK, and only seems to appear in the FSA guidelines in memorandums of understanding with the United States. Firms engaging in investment business generally are required to obtain a license from the FSA. If the currency fund falls under the definition of an unregulated collective investment scheme, as determined by the FSA, the fund can only be communicated or approved for communication to authorized persons, exempt persons, sophisticated investors and high net worth companies. Regardless, under the general FSA rules, any promotions must be made in accordance with the requirement that the

firm must be able to show that it has taken reasonable steps to ensure that the promotion is clear, fair, and not misleading; however, this requirement is often waived for institutional clients. Any information regarding past performance must be tailored to the financial product being promoted and its target audience, and must be presented in such a manner as not to suggest that the past performance projects possible future value. Past performance must also be supported by a record of evidence for the past three years, at the minimum.

There is also the Capital Requirement Directive (CRD), which requires the fund to maintain minimum capital resources to ensure that, if necessary, the fund can be wound up in an orderly manner. Further, the fund must have in place adequate systems and controls to ensure they are in compliance with anti-money laundering laws. Investment conduct is governed by the general principal that the firm is observing proper standards of market conduct.

Germany

Germany has made significant inroads into the foreign exchange market in recent years, largely thanks to its sophisticated electronic trading market, making it an attractive location for fund managers. As Germany does not recognize "commodity pools" as a separate entity, the fund would likely be set up as a hedge fund. Much of hedge fund regulation in Germany is contractual, free from most investment restrictions.

Single hedge funds must adhere to principles of risk diversification, and have contractual provisions covering short sales and the use of leverage through derivatives. However, investment in unregulated markets is limited to 30% of the NAV of the hedge fund. Single hedge funds cannot be publically distributed, and must be privately placed through licensed financial institutions. Further, a full prospectus must be handed over to the investor, with the contractual terms enclosed. Any assets of the fund must be held by an independent custodian bank either domiciled in Germany, or a domestic branch of a foreign bank. Hedge funds investing in other funds cannot invest in derivatives, except to hedge currency risk.

Japan

Japan has also long been considered one of the main foreign exchange centers in the world, although its share in recent years has been slipping. Similarly to the United Kingdom, Japan's financial services industry is regulated by one entity, the Japan Financial Services Agency (JFSA). The JFSA does not define commodity pool operators, or hedge funds for that matter, but as they have many similar characteristics with investment trusts and collective investment schemes, they are likely to face similar regulations. As in the United States, fund managers can be exempted from registration if they target only qualified financial investors. However, they are still subject to supervision by the JFSA, and still have to meet notification requirements. Further, they are also subject to general investing principles, meant to prevent unfair trading.

Brazil

Brazil, a relatively minor player in the foreign-exchange derivatives market, may seem like an unlikely location for a currency fund manager. However, with its rapidly growing economy and stable government, it is a viable option for the fund manager seeking to establish a base in South America. The securities market in Brazil is governed by the Comissão de Valores Mobiliários (CVM). The CVM treats most domestic funds similarly, including hedge funds. Regulations require:

1. registering with the CVM;
2. providing daily NAV information, monthly reporting, and annual financial statements;
3. posting of such information, as well as by-laws and prospectuses, on the Comissão de Valores Mobiliários (CVM) website; and
4. disclosure of risks assumed by the fund considering the impact of derivatives.

International funds are not covered by these requirements, except that, if they are offered to Brazilian investors, they must register with the CVM, and quotas must be negotiated through Brazilian authorized brokers.