The Commodity Exchange Act (the "CEA") was promulgated by Congress in 1974. The CEA accomplished two major goals. First, it established the Commodity Futures Trading Commission as the regulatory authority for the futures industry including the futures exchanges. Second, it established disclosure, record keeping, and reporting rules for commodity pool operators (CPOs), commodity trading advisors (CTAs), futures commission merchants (FCMs), and introducing brokers. It is the rules that regulate CPOs that are most pertinent to hedge fund managers.
8 The key to counting the hedge fund as only one client is to manage the hedge fund in accordance with the terms of the limited partnership agreement or other organization document. In this way, the hedge fund manager is advising only the hedge fund and not its individual investors.
Exhibit 3: The Investment Advisers Act of 1940
CPOs are a subset of the hedge fund universe. These are hedge fund managers who invest primarily in commodity futures contracts. We will discuss their strategies in the section on commodities investing. For now, we are concerned with their regulation.
Section 1.3(cc) of the CEA defines a CPO as:
Any person engaged in a business which is of the nature of an 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 indirectly or through capital contributions, the sale of stock or other forms of securities, or otherwise, for the purpose of trading in any commodity for future delivery or commodity option on or subject to the rules of any contract market, but does not include such persons not within the intent of this definition as the Commission may specify by rule or regulation or order.
In summary, any person who collects money from other individuals for the purpose of investing the money collectively in the commodity futures markets is a commodity pool operator.
If a hedge fund manager is a CPO under the definition of Section 1.3(cc), she must register with the CFTC9 and the National Futures Association under Sections 4(m) and 4(n) and Rule 3.10.
Once registered, a CPO must obey the disclosure document requirements of Sections 4.21 and 4.24, the reporting requirements of Section 4.22, the record keeping requirements of section 4.23, and the performance disclosures of Section 4.25 of the CEA. These sections collectively detail the type of information the CPO must disclose to prospective investors in its offering documents, the financial information that it must present to existing investors in their Account Statements, and the format for presenting performance results in disclosure documents and annual reports. Last, the CPO must keep detailed books and records for the CFTC to audit.
However, as we have seen with respect to the regulation of the financial markets, Congress provided several exemptions from registering as a CPO. The CEA provides three safe harbors for CPOs.
First, under Section 4.5 certain entities are excluded from the definition of the term CPO. These include investment companies registered under the Investment Company Act of 1940, insurance companies, banks, trust companies, ERISA plans, other pension plans, and employee welfare plans. Section 4.5 is meant to exclude any entity that is regulated under another federal law such as the federal securities laws, the Employee Retirement Income Security Act, or federal banking laws. Unfortunately, this exemption has limited application to most hedge funds because they are not otherwise regulated by another federal agency.
To claim an exemption under Section 4.5, an entity must file a notice of eligibility with the CFTC. As part of the notice, the entity must represent that it will use commodity futures or commodity options contracts solely for bona fide hedging purposes.
Second, under Section 4.13, there are two safe harbors. First, Section 4.13(a) exempts a commodity pool operator from registration if: (1) she receives no compensation from operating the pool, (2) she operates only one pool, (3) she does not advertise the pool, and (4) she is not otherwise required to register with the CFTC. Second, section 4.13(b) exempts a CPO from registration if: (1) the total capital contributions received for all pools does not exceed $200,000 and (2) there are no more than 15 participants in any pool. Section 4.13 is meant to apply to the small CPO, most likely someone whose primary business is not managing a commodity pool. It is unlikely to apply to a hedge fund manager whose livelihood depends on receiving income from the pool.
Last, there is Section 4.7. This is the section most applicable to CPO/ hedge fund managers. This section is directed at entities whose primary business
9 All registrations for Commodity Pool Operators as well as other business associated with the futures industry are filed with the National Futures Association. The NFA is the designated self-regulatory authority for the futures industry, and the CFTC has delegated the registration requirements to the NFA.
is managing a commodity pool. Section 4.7 does not exempt a CPO from registering with the CFTC and the NFA and filing annual reports thereto. However, it does exempt the CPO from the disclosure, reporting, and record keeping requirements of Sections 4.21-4.25. The catch is that the CPO must sell its pool interests only to "Qualified Eligible Participants" (QEPs). Additionally the CPO must file a Claim for Exemption with the CFTC.
Section 4.7 provides a long laundry list of the standard types of institutional investors that qualify as a QEPs. These include banks, FCMs, broker-dealers, trusts, other CPOs and commodity trading advisors, insurance companies, investment companies, and pension plans. In addition there is a test for individuals.
For individual investors, the CFTC chose to the use the same requirements for an accredited investor (See Regulation D, above) but with an extra kicker. The accredited investor must also own securities with an aggregate market value of $2,000,000, or the investor must have had on deposit with a futures commission merchant within the last six months $200,000 in initial margin and option premiums for futures contracts and options thereon. Therefore, it is not enough for an accredited investor to have a high net worth or high earning potential, he must also have an existing investment portfolio worth at least $2 million or be actively involved in the futures markets (as demonstrated by his futures account activity).
Despite these three registration exemptions, the anti-fraud provisions of the CEA still apply. Section 6 of the CEA states, in part:
It shall be unlawful for a commodity trading advisor, associated person of a commodity trading advisor, commodity pool operator, or associated person of a commodity pool operator, by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly (A) to employ any device, scheme, or artifice to defraud any client or participant or prospective client or participant; or (B) to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or participant or prospective client or participant.
In conclusion, there are several ways for hedge funds to avoid either registration as a CPO, or the disclosure, record keeping, and reporting requirements for CPOs. These paths are diagrammed in Exhibit 4. However, no matter which path a hedge fund manager might choose, she cannot avoid the anti-fraud section of the CEA.
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