CFTC Rescinds Widely Used Hedge Fund Exemption
February 17, 2012
On February 9, 2012, the Commodity Futures Trading Commission adopted rule amendments that, among other things, rescinded a widely used exemption from registration as a commodity pool operator. The exemption, Rule 4.13(a)(4), was available with respect to any pool that limited U.S. natural person investors to “qualified purchasers” (or met certain alternative criteria) and met certain other conditions. The exemption was created in 2003 and a large number of hedge fund managers currently rely on it. By December 31, 2012, each of these fund managers must either (i) transfer out all U.S. investors (and accept no new U.S. investors), (ii) refrain from trading in exchange-traded futures contracts, (iii) secure an alternative exemption or (iv) register and become fully regulated as a commodity pool operator.
For many fund managers, the most likely alternative exemption will be either (a) under Rule 4.13(a)(3), which provides a full exemption for a fund that limits its futures trading to 5% of the fund, by initial margin, or 100% of the fund, by notional amount, and meets certain other conditions, or (b) under Rule 4.7, which provides a partial exemption from some of the more onerous CFTC requirements for commodity pools, but will require the fund manager to register and submit to regulation as a commodity pool operator, among other requirements.
The CFTC announced its intention to rescind Rule 4.13(a)(4) in January 2011, as part of an initiative to increase regulation of financial markets consistent with the Dodd-Frank Act. The CFTC at that time also proposed to rescind the exemption provided by Rule 4.13(a)(3), but that exemption survived the rule amendments as adopted. New reporting requirements for registered commodity pool operators will tend to drive fund managers away from relying Rule 4.7, particularly those fund managers that will not be registered as investment advisers. Taken together, these developments will cause some fund managers, particularly offshore and smaller fund managers, to carefully analyze whether and how they may become eligible to rely instead on the exemption provided by Rule 4.13(a)(3).
The “5% or 100%” condition of Rule 4.13(a)(3) is satisfied for a fund or other “pool” if either:
The aggregate initial margin, premiums, and required minimum security deposit for retail forex transactions . . . required to establish such 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; Provided, That in the case of an option that is in-the-money at the time of purchase, the in-the-money amount . . . may be excluded in computing such 5 percent
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.
Rule 4.13(a)(3) includes detailed guidance on calculating “net notional amount” and allows netting of futures contracts with the same underlying commodity across designated contract markets and foreign boards of trade and (as amended as part of the current rule amendments) swaps cleared on the same designated clearing organization where appropriate.
 The balance of the conditions of Rule 4.13(a)(3) typically will be satisfied by most private funds: (a) Interests in the fund must be exempt from registration under the Securities Act of 1933, and must be offered and sold without marketing to the public in the United States, and (b) each investor must be an “accredited investor” or meet certain alternative criteria. The fund manager must file a claim of exemption with the National Futures Association, and the fund must prominently disclose that it is relying on the exemption.
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