As we have discussed previously, if a hedge fund manager invests fund assets in commodity interests (including futures), then the manager will generally need to be registered as a commodity pool operator (CPO) with the Commodity Futures Trading Commission (CFTC).  The registration requirement also applies to fund of fund (FOF) managers who allocate assets to underlying hedge funds which themselves invest in commodity interests.  There are a number of CPO exemptions available to hedge fund managers.  Likewise, there are two exemptions which may be applicable to fund of fund managers who allocate to funds CPOs or exempt CPOs.

Potential Exemptions

The two potential exemptions are found in 4.13(a)(4) and 4.13(a)(3) which we will deal with in turn.

Only Qualified Purchasers. Pursuant to CFTC Regulation 4.13(a)(4), if the FOF has only qualified eligible persons (QEP), then it will not need to register as a CPO.  Generally qualified purchasers will qualify as QEPs and so hedge funds which are established as Section 3(c)(7) funds will be able to qualify for this exemption.

De Minimus Futures Trading. Pursuant to CFTC Regulation 4.13(a)(3), if the FOF only has a very small amount of assets allocated to commodity interests, it will not need to register as a CPO.  The test under 4.13(a)(3) is the same as for a regular fund, but the application is different because the structure of the FOF.  Because of the ambiguity, the CFTC specifically provided guidance for FOF managers which allocate to funds which invest in commodity interests.

Note: 4.13(a)(1) and 4.13(a)(2) are also available exemptions, however, these are less often used and are unlikely structures for FOFs.

Three Most Likely Situations

Most FOF managers will fall within the 4.13(a)(3) trading limits (and thus would be exempt from CPO registration) in the following circumstances:

1. All underlying funds all trade within the 4.13(a)(3) trading limits;
2. The FOF manager aggregates all commodity interest positions from the underlying funds to determine if the trading falls within the 4.13(a)(3) limits; or
3. The FOF manager allocates no more than 50% of the FOF assets to funds which trade commodity interests (and the FOF does not trade commodity interests itself).

I have included the actual language from the CFTC adopting release below which provides examples from the CFTC of situations where the FOF manager would fall within the exemption.  Please contact us if you have a question on this issue or if you would like to start a fund of hedge funds.  If you would like more information, please see our articles on starting a hedge fund.

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b. New Appendix A to Part 4: “Fund-of-Funds”

Most of the commenters on proposed Rule 4.13(a)(3), and in fact, on the Proposal as a whole, expressed concern over the application of the Rule 4.13(a)(3) trading limits in the “fund of funds” context.[34] They requested the Commission to confirm in its final rulemaking statements it had made in the Proposal on this issue.[35] They also presented numerous scenarios involving “fund-of-funds” structures for the Commission to consider.

[34] In the ANPR, the Commission defined a “fund-of-funds” as an investor fund that indirectly trades commodity interests through participation in one or more investee funds that directly trades commodity interests. See 67 FR 68785, 68788, n.15.

[35] See 68 FR 12622, 12631.

To address these concerns, the Commission is adopting today Appendix A to Part 4. The introductory text explains that:

The following provides guidance on the application of the trading limits of Rule 4.13(a)(3)(ii) to commodity pool operators (CPOs) who operate “fund-of-funds.” For the purpose of this Appendix A, it is presumed that the investor fund CPO can comply with all of the other requirements of Rule 4.13(a)(3). It also is presumed that where the investor fund CPO is relying on its own computations, the investor fund is participating in each investee fund that trades commodity interests as a passive investor, with limited liability (e.g., as a limited partner of a limited partnership or a non managing member of a limited liability company). Fund-of-fund CPOs who seek to claim exemption from registration under Rule 4.13(a)(1), (a)(2) or (a)(4) may do so without regard to the trading engaged in by an investee fund, because none of the registration exemptions set forth in those rules concerns limits on or levels of commodity interest trading. Persons whose fact situations do not fit any of the scenarios below should contact Commission staff to discuss the applicability of the registration exemption in Rule 4.13(a)(3) to their particular situations.

In adopting Appendix A, the Commission has been guided by the following principles, i.e., that relief under Rule 4.13(a)(3) should be available where:

(1) The CPO of each investee fund is either: (i) itself claiming exemption from CPO registration under Rule 4.13(a)(3); or (ii) a registered CPO that is complying with the trading restrictions of Rule 4.13(a)(3). In this regard, the CPO of the investor fund should be able to rely upon the representations of the investee fund CPOs to the foregoing effect.

(2) The CPO of an investor fund has actual knowledge of the trading and commodity interest positions of the investee funds (e.g., where the investee funds are operated by the CPO or one or more affiliates of the CPO). In this case the investor fund CPO may aggregate the commodity interest positions across the investee funds to determine compliance with the trading restrictions of Rule 4.13(a)(3).

(3) An investor fund does not trade commodity interests directly, and the CPO has allocated no more than 50 percent of the investor fund’s assets to investee funds that trade commodity interests (regardless of the level of commodity interest trading engaged in by those investee pools). The investor fund CPO may claim exemption under Rule 4.13(a)(3) because the investor fund’s exposure to the futures markets may be said to be comparable to that of a standalone pool that meets the aggregate net notional value test.

(4) An investor fund engages in direct commodity interest trading in addition to its allocation of assets to investee funds, provided the CPO treats the assets committed to direct trading as a separate pool with its own liquidation value and applies the trading restrictions of Rule 4.13(a)(3) to that “separate pool.

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APPENDIX A TO PART 4 – GUIDANCE ON THE APPLICATION OF RULE 4.13(a)(3) IN THE FUND-OF-FUNDS CONTEXT

The following provides guidance on the application of the trading limits of Rule 4.13(a)(3)(ii) to commodity pool operators (CPOs) who operate “fund-of-funds.” For the purpose of this Appendix A, it is presumed that the CPO can comply with all of the other requirements of Rule 4.13(a)(3). It also is presumed that where the investor fund CPO is relying on its own computations, the investor fund is participating in each investee fund that trades commodity interests as a passive investor, with limited liability (e.g., as a limited partner of a limited partnership or a non-managing member of a limited liability company). Fund-of-fund CPOs who seek to claim exemption from registration under Rule 4.13(a)(1), (a)(2) or (a)(4) may do so without regard to the trading engaged in by an investee fund, because none of the registration exemptions set forth in those rules concerns limits on or levels of commodity interest trading. Persons whose fact situations do not fit any of the scenarios below should contact Commission staff to discuss the applicability of the registration exemption in Rule 4.13(a)(3) to their particular situations.

1. Situation: An investor fund CPO allocates the fund’s assets to one or more investee funds, none of which meets the trading limits of Rule 4.13(a)(3) and each of which is operated” by a registered CPO. It does not allocate any of the investor fund’s assets directly to commodity interest trading.

Application: The investor fund CPO may claim relief under Rule 4.13(a)(3) provided the investor fund itself meets the trading limits of Rule 4.13(a)(3).

2. Situation: An investor fund CPO allocates the fund’s assets to one or more investee funds, each having a CPO who is either: (1) itself claiming exemption from CPO registration under Rule 4.13(a)(3); or (2) a registered CPO that is complying with the trading restrictions of Rule 4.13(a)(3). It does not allocate any of the investor fund’s assets directly to commodity interest trading.

Application: The investor fund CPO fund may rely upon the representations of the investee fund CPOs that they are complying with the trading limits of Rule 4.13(a)(3).

3. Situation: An investor fund CPO allocates the fund’s assets to investee funds, each of which operates under a percentage restriction on the amount of margin or option premiums that may be used to establish its commodity interest positions (whether pursuant to Rule 4.12(b), Rule 4.13(a)(3)(i)(A) or otherwise), by, e.g., contractual agreement. It does not allocate any of the investor fund’s assets directly to commodity interest trading.

Application: The CPO of the investor fund may multiply the percentage restriction applicable to each investee fund by the percentage of the investor fund’s allocation of assets to that investee fund to determine whether the CPO is operating the investor fund in compliance with Rule 4.13(a)(3)(i)(A).

4. Situation: An investor fund CPO allocates the fund’s assets to one or more investee funds, and it has actual knowledge of the trading limits and commodity interest positions of the investee funds, e.g., where the CPO or one or more affiliates of the CPO operate the investee funds. (For this purpose, an “affiliate” is a person who controls, who is controlled by, or who is under common control with, the CPO.) It does not allocate any of the investor fund’s assets directly to commodity interest trading.

Application: The investor fund CPO may aggregate commodity interest positions across investee funds to determine compliance with the trading restrictions of Rule 4.13(a)(3). For this purpose, the aggregate assets of the investee funds would be compared to the aggregate of their commodity interest positions (as to margin or as to net notional value ). The investor fund CPO should use the results of this computation to determine its compliance with the trading limits of Rule 4.13(a)(3).

5. Situation: An investor fund CPO allocates no more than 50 percent of the fund’s assets to investee funds that trade commodity interests (without regard to the level of commodity interest trading engaged in by those investee pools). It does not allocate any of the investor fund’s assets directly to commodity interest trading.

Application: The investor fund CPO may claim relief under Rule 4.13(a)(3).

6. Situation: An investor fund CPO allocates the fund’s assets to both investee funds and direct trading of commodity interests.

Application: The investor fund CPO must treat the amount of investor fund assets committed to such direct trading as a separate pool for purposes of determining compliance with Rule 4.13(a)(3)(i), such that the commodity interest trading of that pool must meet the criteria of Rule 4.13(a)(3)(i) independently of the portion of investor fund assets allocated to investee funds.