By: Claire L. Hall | Deanna R. Reitman | Jeffrey Bourdon
For commodity markets, Q1 2022 was the best quarter in 30 years. Many markets saw a rally following Russia’s invasion of Ukraine as the war began disrupting shipping in the Black Sea, curtailing the supply of certain products. This, in tandem with such factors as rising inflation and increasing demand for food, led to sharp price swings. Ultimately, the S&P GSCI, a benchmark that tracks commodities futures prices, rose 29 percent in Q1 – the largest gain since 1990. Focusing on trends in the commodity market is important for Israeli companies with investments and locations abroad, and Q1’s promising future is a great sign for investors.
This increased activity could mean that more investment funds may begin to participate in the commodity markets, leading to a rise in trading of such financial products as futures contracts, options, and swaps. Further, it could mean that funds currently participating in these markets and trading these products are planning to expand or increase such activities.
Any fund engaging in, expanding or adding to its commodities trading activities could find itself subject to different, or additional, commodities regulations. Before becoming involved in these markets, it is important to consider and fully understand the regulatory framework.
CPO and CTA registration
The Commodities Futures Trading Commission (CFTC) regulates commodity futures trading in the United States for the purpose of deterring and preventing price manipulation or other disruptions to market integrity. One way the CFTC accomplishes this is by requiring certain persons who satisfy the definition of Commodity Pool Operator (CPO) or Commodity Trading Advisor (CTA) to register as such with the National Futures Association (NFA), or to otherwise prove their exemption from registration or exclusion from the definitions.
Often, questions around registration arise from passive or managed funds or pools of capital, which can include entities that have fund-like characteristics such as real estate investment trusts (REITs) or hedge funds.
Anyone engaged in activities that may qualify them as a CPO or CTA but who has not registered (or renewed a registration), as well as those who are registered (or excluded) but who fail to timely submit required reports or make required disclosures, either to the CFTC itself or customers, can face penalties.
Relief from registration must be affirmatively claimed; those who do not claim exemption status or follow rules applicable to their status (whether claimed or not) may face penalties. In this Commodities Alert, we provide a quick overview of what type of trading triggers “commodity pool” status; then we consider whether a person must register as a CPO or CTA or if an exemption is available.
What is a “commodity pool”?
A commodity pool is any investment trust, syndicate, or similar form of enterprise “operated for the purpose of” trading in commodity interests, and the CFTC may add similar forms of enterprises to this definition. Although commodity pools themselves are not required to register with the CFTC, those operating the commodity pool may face registration requirements. Therefore, we’ll quickly examine what it means to “operate for the purpose of” and, in addition, we will point out certain structures that may not qualify.
The CFTC has repeatedly refused to limit “operate for the purpose of” to its narrowest interpretation – doing so could make the definition underinclusive. Accordingly, funds are encouraged to avoid assuming that the CFTC uses a bright line approach.
Using its stated approach to evaluate all facts and circumstances, the CFTC has identified certain structures that may be excluded from the definition of “commodity pool” and therefore not subject to registration. Entities that may be excluded include:
- A traditional collateralized debt obligation (CDO) structure that owns only financial assets consisting of corporate loans, corporate bonds, or investment grade, fixed income mortgage-backed securities, asset-backed securities or CDO tranches issued by vehicles that are not commodity pools
- A repackaging vehicle that issues credit-linked or equity linked notes where the repackaging vehicle owns high quality financial assets but sells credit protection on a broad-based index or obtains exposure to a broad based stock index through a swap
- A REIT that primarily derives its their income from the ownership and management of real estate and that use derivatives for the limited purpose of “mitigating their exposure to changes in interest rates or fluctuations in currency
- General account entities formed by state-regulated insurance companies that combine general account assets and invest directly or indirectly in commodity interests and
- Certain securitization vehicles
When must a person register as a CPO?
A person who qualifies as a CPO must register with the NFA, unless this person is eligible for an exemption or exclusion (see below). Even if the person who qualifies as a CPO is an entity, it must submit files for its principals and associated persons. For example, in the context of a fund, CPOs are often the general partner of a limited partnership, the managing member or manager of a limited liability company, the trustees of a trust, or the directors of a corporation.
A CPO is any person engaged in a business that is of the nature of a commodity pool, investment trust, syndicate, or similar form of enterprise, and who, in connection therewith, solicits, accepts, or receives from others, funds, securities, or property, either directly or through capital contributions, the sale of stock or other forms of securities, or otherwise, for the purpose of trading in commodity interests. This is not a close looped definition; the CFTC reserves the ability to exclude from the term CPO any person who otherwise satisfies the definition when doing so would further the purposes of the Commodity Exchange Act.
Depending on the entity the person, and any principal or employee thereof, manages, such person (or its principals and employees) can either be exempt or excluded, in both cases either partially or fully, from satisfying certain responsibilities of a CPO. However, even if a person is exempt or excluded, partially or fully, this does not mean CFTC rules are now inapplicable. Instead, it means such a person has certain relief from certain responsibilities. For example, antifraud restrictions still apply.
Who is exempt?
Full exemption. Generally, the following persons are exempt from CPO registration:
- Operates only one pool at any time, does not advertise, receive compensation and is not otherwise required to be registered with the CFTC
- Operates a pool where the total gross capital contributions in all pools operated or intended to be operated does not (in the aggregate) exceed $400,000, and none of the pools operated has more than 15 participants
- Operates a pool that trades only minimal amount of futures, and participation is restricted to accredited investors, a trust formed by an accredited investor for benefit of a family member, knowledgeable employees or a qualified eligible person and can satisfy one of two tests: (i) the aggregate initial margin and premiums do not exceed 5 percent of the liquidation of the pool’s portfolio, and (ii) the aggregate net notional value of positions does not exceed 100 percent of the liquidation value of the pool’s portfolio
- Operates a pool in compliance with certain securities regulations, which is provide that (i) the person acts solely to comply with SEC rules and exchange listing requirements that require the pool to have an audit committee comprised of independent directors, (ii) the person has no power or authority to manage or control the operations or activities of the pool, and (iii) the registered CPO of the pool is and will be liable for any violation of the CEA or CFTC in connection with such person’s service as a director or trustee.
Those claiming an exemption must claim it by following CFTC regulations.
Partial exemption. Any person who is registered as a commodity pool operator, or has applied for such registration, may claim any or all of disclosure relief stated in CFTC regulations for the pool for which such person would make a claim if the pool:
- Will be offered and sold pursuant to the Securities Act of 1933 or an exemption from such Act
- Will generally and routinely engage in the buying and selling of securities and securities derived instruments
- Will not enter into commodity interest transactions for which the aggregate initial margin and premiums, and required minimum security deposit for retail forex transactions exceed 10 percent of the fair market value of the pool’s assets, after taking into account unrealized profits and losses on any contracts it has entered into; provided, however, that for an option that is in-the-money at the time of purchase, the in-the-money amount may be excluded in computing such 10 percent and
- Will trade such commodity interests in a manner solely incidental to its securities trading activities, provided that for each existing participant and prospective participant in the pool for which relief is claimed has been informed in writing of certain restrictions set forth in CFTC regulations.
Separately, any person who is registered as a commodity pool operator, or has applied for such registration, may claim any or all of disclosure relief stated in CFTC regulations for the pool for which such person would make a claim if:
- The units of participation in such pool will be offered and sold pursuant to an effective registration statement under the Securities Act of 1933 or
- The pool is registered under the Investment Company Act of 1940.
Who may be excluded?
Full exclusion. Full exclusions are available for the following persons (and any principal or employee of such person), if the entity that engages the person is a qualifying entity:
- An investment advisor who is registered under the Investment Company Act of 1940; a qualifying entity for this person is one registered under the Investment Company Act of 1940, or a business development company elected an exemption from registration as an investment company
- Insurance company subject to regulation by any State; a qualifying entity for this person is one with a separate account that is established and maintained or offered by an insurance company pursuant to the laws of any State or territory, under which income gains and losses, whether or not realized, from assets allocate to such account, are, in accordance with the applicable contract and credited to or charged against the account
- A bank, trust company or any other such financial depository institution subject to regulation by any state or the United States; a qualifying entity for this person is one who is acting as a fiduciary for which it is vested with investment authority and
- A trustee of a named fiduciary or employer maintaining a pension plan subject to the Employee Retirement Income Security Act – provided, however, that for purposes of qualifying for an exclusion, the following employee benefit plans are not construed to be pools:
Partial exclusion. Exclusion from certain CPO requirements is also available to the following commodity pool operators with respect to the pool(s) they operate, provided such operator files the required notice and operates the exempt pool(s) in compliance with CFTC rules:
- Noncontributory plan, whether defined benefit or defined contribution
- A contributory defined plan covered under title IV of ERISA, provided, however, that with respect to any plan to which an employee may voluntarily contribute, no portion of an employee’s contribution is committed as margin or premiums for futures or options contracts
- A plan defined as a governmental plan by ERISA
- Any employee welfare benefit plan that is subject to the fiduciary responsibility provisions of ERISA and
- A plan defined as a church plan by ERISA.
- Any registered commodity pool operator who offers or sells participations in an offering exempt from registration under Section 4(a)(2) of the Securities Act of 1933, which exempts from registration transactions by an issuer not involving any public offering, to qualified eligible persons, without marketing to the public, may claim any or all of the disclosure relief, periodic reporting relief, annual report relief and recordkeeping relief available in CFTC regulations; provided that the prohibition on marketing to the public doesn’t apply to a registered commodity pool operator who offers or sells participations in a pool offered pursuant to 17 C.F.R. §230.506(c), which requires, among other things, that all purchases are accredited investors
- Any registered commodity pool operator who offers or sells participations in an offering that is offered pursuant to 17 C.F.R. §§230.901 thru 230.905, which includes, among other things, offerings outside the United States, solely to qualified eligible persons, without marketing to the public, may claim any or all of the disclosure relief, periodic reporting relief, annual report relief and recordkeeping relief available in CFTC regulations and
- Any bank registered as a commodity pool operator that offers or sells participations in a pool that is a collective trust fund, the securities of which are exempt from registration pursuant to Section 3(a)(2) of the Securities Act of 1933, which exempts securities guaranteed by a bank, to qualified eligible persons, without marketing to the public, may claim any or all of the disclosure relief, periodic reporting relief, annual report relief and recordkeeping relief available in CFTC regulations.
Whether a person is a “qualified eligible person” is subject to an extensive, fact-specific analysis.
When must a person register as a CTA?
A CTA is a broadly defined to be a person who, for compensation or profit, directly or indirectly advises others as to the value or the advisability of trading in commodity interests, or regularly issues or promulgates analyses or reports concerning commodity interests, and the CFTC may also determine that a person outside this definition also qualifies as a CTA.
A person may be exempt or excluded, in either case fully or partially, from certain obligations otherwise applicable to those satisfying the definition of CTA. However, even if a person is exempt or excluded, partially or fully, this does not mean CFTC rules are now inapplicable. Instead, it means such a person has certain relief from certain responsibilities.
Who is exempt?
Full exemption. Generally, the following persons are not required to register as a CTA:
- The person is a dealer, processor, broker, or seller in cash market transactions of any commodity and the person’s commodity trading advice is solely incidental to the conduct of its cash market business
- It is a nonprofit, voluntary membership, trade association or farm organization and the person’s commodity trading advice is solely incidental to the conduct of its business as such association or organization,
- It is registered under the Commodity Exchange Act as an associated person and the person’s commodity trading advice is issued in connection with tis employment as an associated person,
- It is registered as a CPO and the person’s commodity trading advice is directed solely to, and for the sole use of, the pool or pools for which it is registered
- It is exempt from registration as a CPO and the person’s commodity trading advice is directed solely to, and for the sole use of, the pool or pools for which it is exempt
- It is registered as an introducing broker, leverage transaction merchant or retail foreign exchange dealer and such person’s trading advice is solely in connection with its business as such
- It is registered as an investment advisor under the Investment Advisers Act of 1940 or with the applicable securities regulatory agency of any State, or it is exempt from such registration, or excluded from the definition of the term “investment advisor”, provided that certain conditions are met, including that the person’s commodity interest trading advice is directed solely to, and for the sole use of, one or more of the following (i) qualifying entities for which a notice has been filed, (ii) collective investment vehicle that is excluded from the definition of the term commodity pool, and (iii) certain commodity pools organized and operated outside of the US, its territories or possessions
- It does not direct client accounts or provide commodity trading advice or provide commodity trading advice based on the commodity interest or cash market positions or other circumstances of particular clients
- It has not furnished commodity trading advice to more than 15 persons during the course of the preceding 12 months and it does not hold itself out generally to the public as a CTA and
- The commodity trading advice is solely directed to, and is for the sole use of, family clients.
Additionally, the CFTC has also ruled that certain swap dealers, de minimis dealers, agent affiliates, and associated persons are not required to register as commodity trading advisors under certain circumstances.
Partial exemption. Any registered commodity trading advisor who anticipates directing or guiding the commodity interest accounts of qualified eligible persons may claim any or all of the disclosure and recordkeeping relief available in CFTC regulations, provided such person files the required notice and otherwise complies with CFTC regulations.
Who is excluded?
Full exclusion. The CTA definition specifically excludes the following if the commodity advice is solely incidental to the conduct of their business or profession:
- Any bank or trust company or any person acting as an employee thereof
- Any news reporter, news columnist, or news editor of the print or electronic media, or any lawyer, accountant, or teacher
- Any floor broker or futures commission merchant,
- The publisher or producer of any print or electronic data of general and regular dissemination, including its employees
- The fiduciary of any defined benefit plan that is subject to the ERISA
- Any contract market or derivatives transaction execution facility or
- Other persons as the CFTC may specify by rule, regulation, or order.
Despite not being excluded by the definition of CTA, CFTC regulations have established that the following three types of persons, and any principal or employee thereof, are also excluded from the definition of CTA:
- An insurance company subject to regulation by any state or any wholly owned subsidiary or employee of it, provided that its commodity interest advisory activities are solely incidental to the conduct of the insurance business of the insurance company
- A person excluded from the definition of CPO, provided that its commodity interest advisory activities are solely incidental to its operation of those trading vehicles for which the exclusion from the CPO definition provides relief, and where necessary, before providing any commodity interest trading advice to any such trading vehicle the person files a notice of eligibility for an exclusion from the CPO definition in accordance with CFTC regulations and
- Swap dealers registered with the CFTC as such or excluded or exempt from registration, provided that the commodity interest and swap advisory activities of the swap dealer are solely incidental to the conduct of its business as a swap dealer.
Accordingly, all exclusion from CTA registration requires a fact-intensive analysis of whether an activity is “solely incidental.” Because the CFTC may make “special calls” upon a person (or such person’s principal or employee claiming an exclusion) asking such person to demonstrate why an exclusion is applicable, all persons trading in commodities, however slightly, are encouraged to engage in a “solely incidental” analysis.
Partial exclusion. The relief for partial exclusion from the CTA definition is the same as noted in the partial exemption relief above.
As commodities markets present more investment opportunities and investors enter these markets or expand their activities in the commodities markets, it is important for funds to understand the CFTC regulations applicable to CPOs and CTAs.
A first step for funds is to gain understanding of their status as a commodity pool, CPO and/or CTA. Further, and although not overly burdensome, once determining its status, a fund should also seek to gain an understanding of the ongoing compliance obligations for such status (which could be reduced for certain CPOs and CTAs even if they are not fully exempt or excluded).
To learn more about CFTC CPO and CTA regulation, including exclusions, exemptions, registration requirements and corresponding compliance requirements, please contact any of us at DLAPiperCommodities@dlapiper.com.