Category Archives: Commodities and Futures

NFA Petitions CFTC to Amend Rule 4.5

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Wants Managers of Commodity/Futures Mutual Funds to Register as CPOs

On August 18, 2010, the NFA filed a revised Petition for Rulemaking with the CFTC requesting that it amend CFTC Rule 4.5 with respect to managers to mutual funds which offer futures and commodities investment opportunities.  Generally, a manager operating a mutual fund that invests in futures and commodities would be a commodity pool operator and would need to register as such with the CFTC.  However, under current CFTC Rule 4.5, the manager could seek exclusion from such registration.  The NFA has become concerned about mutual funds that are not subject to the CFTC/NFA regulatory regime and that are marketed to retail customers as a way to invest in futures and commodities.  The NFA is requesting amendment of Rule 4.5 to restrict this kind of activity.

Background

CFTC Rule 4.5 provides an exclusion from the definition of the term “commodity pool operator” for certain otherwise regulated persons in connection with their operation of specified trading vehicles, including investment companies registered under the Investment Company Act of 1940.

Prior to August 2003, mutual fund managers seeking eligibility for exclusion under Rule 4.5 were required to meet the following requirements:

  • they could not market participation in the mutual fund as participation in a commodity pool or a vehicle for trading commodities or futures;
  • they had to represent that commodity futures or options contracts entered into by the fund were for bona fide hedging purposes; and
  • they had to demonstrate that the aggregate initial margin and/or premiums for non-hedging positions did not exceed 5% of the liquidating value of the fund’s portfolio (after taking into account unrealized profits and losses).

In August 2003, the CFTC eliminated these requirements as a condition to be eligible under Rule 4.5.  The NFA is now petitioning for the CFTC to restore these conditions for eligibility.

NFA Petition for Rulemaking

The NFA’s Petition discusses the context for requesting this amendment.  In particular, the NFA has become aware of three mutual funds that recently filed for exclusions under Rule 4.5.  These funds are marketed as vehicles for commodity futures investment, with investments in derivatives and futures products made indirectly through their wholly-owned and controlled subsidiaries (for tax and mutual fund regulatory purposes).  In one case, a fund invests up to 25% of its total assets in a subsidiary that leverages assets at a 4:1 ratio–achieving a futures exposure of the full net value of the fund.

The NFA is concerned that such funds, which are active in the commodity futures industry, are not regulated as CPOs by the CFTC and NFA.  The futures mutual fund manager can file a notice with the NFA claiming the Rule 4.5 exclusion under the Commodity Exchange Act, as amended.  Accordingly, the fund is not subject to registration or regulation as a commodity pool.  Through its Petition, the NFA seeks to ensure that managers of registered investment companies that are marketed as a commodity pool or an investment vehicle for trading in commodity futures and options and whose funds engage in more than 5% of futures are subject to the appropriate oversight and regulatory requirements.

“No-Marketing” and the 5% Limitation

At the time the CFTC amended Rule 4.5, it also adopted Rule 4.13(a)(4) to provide an exemption to CPO registration if every natural person pool participant is a “qualified eligible person.”  The NFA argues that to the extent this exemption served as a reason to eliminate the “no marketing” and “5% trading test” from Rule 4.5, the CFTC should reexamine whether such reasoning is still valid.

When the CFTC amended these rules, it did so under the presumption that the qualifying entities, such as the mutual funds discussed in this article, were “otherwise regulated” and “may not need to be subject to any commodity interest trading criteria.”  But, the NFA is asserting that things have changed since the 2003 amendment and the rationale for the amendments is arguably no longer appropriate or valid.  Such registered investment companies that market themselves as a commodity pools or vehicles for trading in commodity futures or options to retail customers, who may be unsophisticated investors, or engage in more than 5% of non-hedging futures trading should be subject to the rules and regulations of the CFTC and NFA, the appropriate regulatory regime that protects customers participating in the commodity futures markets.

Comments by CFTC Commissioner

On September 1, 2010, CFTC Commissioner Scott O’Malia released a statement regarding the NFA petition which urged the CFTC to “expeditiously” move forward and adopt the NFA’s requested amendments.  The Commissioner stated:

Until the recent influx of new mutual funds specializing in futures trading, the use of the exclusion, in effect a form of regulatory arbitrage, was innocuous. However, continuing to allow FMFs to operate by evading CFTC oversight and its substantial disclosure obligations now poses increased risks to the market and to retail investors.

and

Without CFTC and NFA oversight, FMFs and other such funds that mimic CPOs, but do not abide by the same structure, will continue to avoid specific disclosures mandated for CPOs in the interest of consumer protection including: disclosures over fund risk exposure; performance returns; fee structures; and advisor conflict of interest information.

Future of Rule 4.5

It is clear that a new Rule 4.5 would be fiercely contested by current mutual fund managers who are investing in futures/commodities.  The big issue for managers will be an increase in start-up and compliance costs as well an increase in infrastructure requirements to comply with CFTC Regulations.  This will undoubtedly increase costs to mutual fund investors (and, the NFA argues, potentially increase investor protection).

However, nothing has happened yet.  Although the NFA asked the CFTC to amend the regulation, the CFTC will need to publish proposed amendments for public comment.  After receiving comments, the CFTC would be permitted to issue final regulations.  However, we do not think it is likely that the CFTC is going to focus its rule making (amending) efforts on issues that don’t fall under the Dodd-Frank act.  As the CFTC is under-resourced for this requirements of Dodd-Frank, it is unlikely to take up any outside initiatives over the next 9-12 months as they focus on other rule making efforts such as the OTC derivatives reform.

Other resources:

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Cole-Frieman & Mallon LLP provides comprehensive CFTC and NFA compliance and regulatory support for investment managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Exemptive Relief from CPO Annual Audit Requirement

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Managers starting a commodity fund at the end of the year may seek relief from annual audit requirement

CFTC Regulations 4.22(c) and (d) require that each registered CPO file a certified annual report with the CFTC and distribute copies to pool participants within 90 calendar days after the pool’s fiscal year (“audit requirement”).  The principal purpose of these requirements is to ensure that pool participants (fund investors) receive accurate, fair, and timely information on the overall trading performance and financial condition of the pool.  In a situation where a futures/commodities hedge fund was established only a few months or so before the end of the fiscal year, conducting a certified audit at the end of the fiscal year may not be desirable due to costs.  Relief may be available to managers in this situation.  The CPO can request an exemption from the audit requirement from the CFTC.

This article explains how a manager can go about requesting and obtaining an exemption.

Exemptions on a Case-by-Case Basis

The CFTC’s Division of Clearing and Intermediary Oversight (“DCIO”) will grant or deny exemptive relief from the audit requirement on a case-by-case basis, based on each individual CPO’s factual circumstances.  When we spoke informally to a staff member at DCIO, he said that there is no prescriptive list of conditions that will automatically result in exemptive relief but the main factors they seem to take into account are:

  1. the pool has only a handful of participants,
  2. the pool has only a nominal amount of capital contributed and a nominal amount of total net assets, and
  3. each of the participants in the pool has provided a written waiver consenting to the CPO’s exemption from the audit requirement.

In many cases where the exemption was granted, DCIO still placed the following conditions on the CPO:

  1. the CPO must distribute unaudited annual reports to each of the pool’s participants (these unaudited annual reports must otherwise comply with the provisions of CFTC Regulations 4.22(c) and (d)–reprinted in full below), and
  2. at the close of the following fiscal year, the CPO must file an audited annual report that includes the previous unaudited period.

Requesting the Exemption by Email or Letter

DCIO seems to grant exemptions from the audit requirement in response to email or letter  requests from CPOs.  In a 2009 DCIO letter granting exemptive relief, the CPO sent an email to DCIO requesting the exemption.  DCIO found that granting relief in the CPO’s situation was not contrary to Regulation 4.22 nor the public interest.  In particular, it focused on the following facts:

  • the pool began operations in September of 2008,
  • the pool only had 8 participants,
  • the pool had total capital contributions between $300,000-$400,000 as of December of 2008,
  • the pool’s net asset value was between $60,000-$70,000, and
  • the CPO attached waivers from the 8 participants indicating their consent to the exemption.

In a 2010 DCIO letter, DCIO granted the exemption after a CPO sent DCIO a letter requesting the relief and attaching the client waivers.  DCIO reviewed the facts and found granting the exemption was not contrary to Regulation 4.22 nor the public interest.

It is important to note that exemptive letters bind DCIO only with respect to the specific fact situation and persons addressed by the letter and third parties may not rely upon it.  For a full explanation of the CFTC’s exemptive letters, visit the CFTC’s discussion on this topic.  If you are interested in filing for such exemptive relief with respect to your commodity pool, please contact Mallon P.C.

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Cole-Frieman & Mallon LLP provides comprehensive hedge fund start up and regulatory support for commodity pool operators.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Litigation Statement for CTA and CPO Disclosure Documents

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One of the more important requirements with respect to drafting the CTA and CPO Disclosure Documents is making sure that all appropriate litigation statements are included in the documents.  Under CFTC Regulations 4.24 (CPOs) and 4.34 (CTAs) the manager is required to disclose the litigation history of: (i) the management company, (ii) principals of the management company and (iii) the FCM and IB.  While (i) and (ii) are generally going to be easy to prepare, getting the litigation history for the FCM and IB will be dependent on the FCM and IB providing the manager or the manager’s attorney with a litigation statement.  Some FCMs and IBs do not have a litigation history and a statement to that effect will need to be included in the disclosure documents.

Below we have included more information on this requirement from the NFA Disclosure Document Guide and we have included the text of the CFTC Regulations.

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From the NFA guide to disclosure documents:

Litigation

The Document must disclose any material administrative, civil or criminal action, whether pending or concluded, within five years preceding the date of the Document, against the following persons (a concluded action that resulted in adjudication on the merits in favor of such person need not be disclosed):

…

• The pool’s FCM and IBs, if any.

With respect to an FCM or an IB, an action is material if:

• The action would be required to be disclosed in the notes to the FCM’s or IB’s financial statements prepared pursuant to generally accepted accounting principles;

• The action was brought by the Commission (unless the action was concluded, did not result in civil monetary penalties exceeding $50,000, and did not involve allegations of fraud or other willful misconduct); or

• The action was brought by any other federal or state regulatory agency, a non-United States regulatory agency or a self-regulatory organization and involved allegations of fraud or other willful misconduct.

Where a matter is material, its description must include a recital of the nature of the action, the parties involved, the allegations or findings, the status of the action and the size of any fine or settlement.

Source: pages 34 and 35 of the disclosure document guide.

CFTC Regulation 4.24(l)

Litigation.

(1) Subject to the provisions of §4.24(l)(2), any material administrative, civil or criminal action, whether pending or concluded, within five years preceding the date of the Document, against any of the following persons; Provided, however, that a concluded action that resulted in an adjudication on the merits in favor of such person need not be disclosed:

(i) The commodity pool operator, the pool’s trading manager, if any, the pool’s major commodity trading advisors, and the operators of the pool’s major investee pools;

(ii) Any principal of the foregoing; and

(iii) The pool’s futures commission merchants and introducing brokers, if any.

CFTC Regulation 4.34(k)

Litigation.

(1) Subject to the provisions of §4.34(k)(2), any material administrative, civil or criminal action, whether pending or concluded, within five years preceding the date of the Document, against any of the following persons; Provided, however, that a concluded action that resulted in an adjudication on the merits in favor of such person need not be disclosed:

(i) The commodity trading advisor and any principal thereof:

(ii) Any futures commission merchant with which the client will be required to maintain its commodity interest account; and

(iii) Any introducing broker through which the client will be required to introduce its account to the futures commission merchant.

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Cole-Frieman & Mallon LLP provides comprehensive hedge fund start up and regulatory support for commodity pool operators.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

NFA Changes Post CFTC Audit

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The results of the CFTC’s audit of the NFA were released a few weeks ago and we have already begun to see a few changes to the way the NFA operates.

Access to BASIC Security Manager

Previously newly formed entities which were registering with the CFTC could start the registration process prior to formally being established.  Now, the NFA must have proof that the entity is in existence prior to granting security manager status.  Accordingly, groups wishing to register must wait until the entity is in existence and then submit the security manager form.  This will usually delay an initial application by about a week. We believe it would be more effective if the NFA made sure that the entity was established prior to submitting a registration application.  Absent such procedures, we believe that the security manager process should be streamlined and that access should be granted next day via email.  There is no good reason to have such a slow process just to access the online registration system.

Client withdrawals from account

Previously it was common for some CTAs to have some sort of lock-up period with respect to a trading program.   Now, the NFA will not allow a CTA to have a lock-up period because the client is always able to go to the FCM and cancel the account.  While from a technical perspective the client always has access to its own account and the CTA can’t control access to the account, many CTAs preferred the implicit protection afforded through the contractual agreement that the account would stay open during the lock-up.   By not allowing the lock-up language, CTAs will potentially be subject to greater and more frequent withdrawals from investors.

Revising Disclosure Documents

Many NFA Member firms will find out about the various new NFA procedures during the disclosure document revision process.  Moving forward, various deficiencies with disclosure documents that have been approved by the NFA in the past will need to be fixed (even though the documents were previously approved) as the managers revise the documents and seek instant filing or regular filing.

Please let us know if you have experienced any other changes with the NFA.

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Cole-Frieman & Mallon LLP provides comprehensive hedge fund start up and regulatory support for commodity pool operators.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Emerging CTA Contest

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Futures Magazine Looks to Profile “Hot New CTAs”

Futures magazine is looking to profile new CTAs for their annual feature entitled “Hot New CTAs.”  The requirements for potential inclusion in the survey include:

  • have managed customer funds for at least one year as of the end of August
  • have less than $25 million of AUM
  • have a disclosure document
  • have an audited track record

If you are interested, you should pick up a copy of Futures magazine.  The deadline for submissions is August 20.

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Cole-Frieman & Mallon LLP provides legal support as well as CTA and CPO registration services to futures and commodities advisors.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Dodd-Frank Establishes New Laws Regarding Spot Commodities and Spot Forex

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The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Act”) has changed a number of laws in all of the securities acts including the Commodity Exchange Act.  Two specific changes deal with certain transactions in commodities on the spot market.  Specifically, Section 742 of the Act deals with retail commodity transactions.  In this section, the text of the Commodity Exchange Act is amended to include new Section 2(c)(2)(D) (dealing with retail commodity transactions) and new Section 2(c)(2)(E) (prohibiting trading in spot forex with retail investors unless the trader is subject to regulations by a Federal regulatory agency, i.e. CFTC, SEC, etc.).  According to a congressional rulemaking spreadsheet, these are effective 180 days from the date of enactment.

We provide an overview of the new sections and have reprinted them in full below.

New CEA Section 2(c)(2)(D) – Concerning Spot Commodities (Metals)

The central import of new CEA Section 2(c)(2)(D) is to broaden the CFTC’s power with respect to retail commodity transactions.  Essentially any spot commodities transaction (i.e. spot metals) will be subject to CFTC jurisdiction and rulemaking authority.  There is an exemption for commodities which are actually delivered within 28 days.  While the CFTC wanted an exemption in which commodities would need to be delivered within 2 days, various coin collectors were able to lobby congress for a longer delivery period (see here).

It is likely we will see the CFTC propose regulations under this new section and we will keep you updated on any regulatory pronouncements with respect to this new section.

New CEA Section 2(c)(2)(E) – Concerning Spot Forex

The central import of new CEA Section 2(c)(2)(E) is to regulate the spot forex markets.  While the section requires the CFTC to finalize regulations with respect to spot forex (which were proposed earlier in January), it also, interestingly, provides  oversight of the markets to other federal regulatory agencies such as the CFTC.  This means that in the future, different market participants may be subject to different regulatory regimes with respect to trading in same underlying instruments.  A Wall Street Journal article discusses the impact of this with respect to firms which engage in other activities in addition to retail forex transactions.  The CFTC’s proposed rules establish certain compliance parameters for retail forex transactions, requires registration of retail forex managers and requires such managers to pass a new regulatory exam called the Series 34 exam.  We do not yet know whether the other regulatory agencies will adopt rules similar to the CFTC or if they will write rules from scratch.

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CEA Section 2(c)(2)(D)

‘‘(D) RETAIL COMMODITY TRANSACTIONS.—

‘‘(i) APPLICABILITY.—Except as provided in clause (ii), this subparagraph shall apply to any agreement, contract, or transaction in any commodity that is—

‘‘(I) entered into with, or offered to (even if not entered into with), a person that is not an eligible contract participant or eligible commercial entity; and

‘‘(II) entered into, or offered (even if not entered into), on a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis.

‘‘(ii) EXCEPTIONS.—This subparagraph shall not apply to—

‘‘(I) an agreement, contract, or transaction described in paragraph (1) or subparagraphs (A), (B), or (C), including any agreement, contract, or transaction specifically excluded from subparagraph (A), (B), or (C);

‘‘(II) any security;

‘‘(III) a contract of sale that—

‘‘(aa) results in actual delivery within 28 days or such other longer period as the Commission may determine by rule or regulation based upon the typical commercial practice in cash or spot markets for the commodity involved; or

‘‘(bb) creates an enforceable obligation to deliver between a seller and a buyer that have the ability to deliver and accept delivery, respectively, in connection with the line of business of the seller and buyer; or

‘‘(IV) an agreement, contract, or transaction that is listed on a national securities exchange registered under section 6(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78f(a)); or

‘‘(V) an identified banking product, as defined in section 402(b) of the Legal Certainty for Bank Products Act of 2000 (7 U.S.C.27(b)).

‘‘(iii) ENFORCEMENT.—Sections 4(a), 4(b), and 4b apply to any agreement, contract, or transaction described in clause (i), as if the agreement, contract, or transaction was a contract of sale of a commodity for future delivery.

‘‘(iv) ELIGIBLE COMMERCIAL ENTITY.—For purposes of this subparagraph, an agricultural producer, packer, or handler shall be considered to be an eligible commercial entity for any agreement, contract, or transaction for a commodity in connection with the line of business of the agricultural producer, packer, or handler.’’.

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CEA Section 2(c)(2)(E)

‘‘(E) PROHIBITION.—

‘‘(i) DEFINITION OF FEDERAL REGULATORY AGENCY.—In this subparagraph, the term ‘Federal regulatory agency’ means—

‘‘(I) the Commission;

‘‘(II) the Securities and Exchange Commission;

‘‘(III) an appropriate Federal banking agency;

‘‘(IV) the National Credit Union Association; and

‘‘(V) the Farm Credit Administration.

‘‘(ii) PROHIBITION.—

‘‘(I) IN GENERAL.—Except as provided in subclause (II), a person described in subparagraph (B)(i)(II) for which there is a Federal regulatory agency shall not offer to, or enter into with, a person that is not an eligible contract participant, any agreement, contract, or transaction in foreign currency described in subparagraph (B)(i)(I) except pursuant to a rule or regulation of a Federal regulatory agency allowing the agreement, contract, or transaction under such terms and conditions as the Federal regulatory agency shall prescribe.

‘‘(II) EFFECTIVE DATE.—With regard to persons described in subparagraph (B)(i)(II) for which a Federal regulatory agency has issued a proposed rule concerning agreements, contracts, or transactions in foreign currency described in subparagraph (B)(i)(I) prior to the date of enactment of this subclause, subclause (I) shall take effect 90 days after the date of enactment of this subclause.

‘‘(iii) REQUIREMENTS OF RULES AND REGULATIONS.—

‘‘(I) IN GENERAL.—The rules and regulations described in clause (ii) shall prescribe appropriate requirements with respect to—

‘‘(aa) disclosure;

‘‘(bb) recordkeeping;

‘‘(cc) capital and margin;

‘‘(dd) reporting;

‘‘(ee) business conduct;

‘‘(ff) documentation; and

‘‘(gg) such other standards or requirements as the Federal regulatory agency shall determine to be necessary.

‘‘(II) TREATMENT.—The rules or regulations described in clause (ii) shall treat all agreements, contracts, and transactions in foreign currency described in subparagraph (B)(i)(I), and all agreements, contracts, and transactions in foreign currency that are functionally or economically similar to agreements, contracts, or transactions described in subparagraph (B)(i)(I), similarly.’’.

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Cole-Frieman & Mallon LLP provides legal support and forex registration services to forex managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Commodity Position Limits After Dodd-Frank

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CFTC to Establish Energy Position Limits

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Act”) includes a number of key provisions which will affect the investment management industry in important ways. For example, the Act includes a mandate for the CFTC to impose position limits across different markets, including the energy markets, the agricultural markets and with respect to trading in certain OTC derivatives. These new position limits must be implemented by CFTC orders or through rulemakings within the next six to nine months depending on the individual markets.

New CEA Section 4a(c)

The Act establishes new SEC Section 4a(c), portions of which we have reprinted below. Generally the new sections will require the CFTC to do the following:

  • establish limits on “exempt commodities” within 180 days of the passage of the Act. [The term “exempt commodity” is defined in CEA Section 1a(14) to generally include those commodities which are not financially based commodities and not agricultural commodities. Generally the import of this provision is to have the CFTC implement position limits on energy related commodities and futures.]
  • establish limits on agricultural commodities within 270 days of the passage of the Act.
  • establish the aggregate number or amount of positions in certain contracts based upon the same underlying commodity that may be held by any person, including any group or class of traders, for each month.

The above requirements are generally subject to “bona fide hedging” exemptions and the new Section 4a(c)(2) requires the CFTC to define what constitutes a bona fide hedging transaction.

* Please note the above is a broad generalization of the applicable new sections of the CEA

CFTC’s Previous Efforts to Set Energy Position Limits

To an extent, we will look to the CFTC’s prior efforts to see where they may land with respect to setting limits. In January 2010, the CFTC proposed position limits designed to prevent any one participant from developing a concentration of futures positions (see generally Federal Register Release 75 FR 4143). The proposed limits would have restricted the position energy traders could hold and addressed concerns many lawmakers had about the connection between those traders and rising energy prices. While the proposed limits only applied to four exchange-traded energy commodities (crude oil, natural gas, and two other types of fuel), the CFTC will be revisiting those efforts to meet the new, more expansive mandate under the Wall Street Reform Act. [Note: you can view previous comments from the public on this issue on the CFTC website.]  The CFTC will be working with other agencies, including the SEC, the Federal Reserve Board, and other regulators in its efforts.

Likely Impact

These mandates will have a significant impact on the energy futures market. In 2009, more than 377 million energy futures and options contracts were traded on CFTC-regulated exchanges and this number is anticipated to increase. Energy traders will now face position limits with respect to the energy contracts that were previously largely unregulated. In addition, it is important to note that under the Act, the CFTC can set position limits not only on persons, but also on any “group or class of traders”–which means it could apply a limit, for example, to all airlines in the aggregate. While we will not know the full impact for some time, when the limits are implemented there are likely to be some groups and individuals who will need to carefully monitor their positions.

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New CEA Provisions

Section 4a(a)(2) of the Commodity Exchange Act

‘‘(2) ESTABLISHMENT OF LIMITATIONS.—

‘‘(A) IN GENERAL.—In accordance with the standards set forth in paragraph (1) of this subsection and consistent with the good faith exception cited in subsection (b)(2), with respect to physical commodities other than excluded commodities as defined by the Commission, the Commission shall by rule, regulation, or order establish limits on the amount of positions, as appropriate, other than bona fide hedge positions, that may be held by any person with respect to contracts of sale for future delivery or with respect to options on the contracts or commodities traded on or subject to the rules of a designated contract market.

‘‘(B) TIMING.—

‘‘(i) EXEMPT COMMODITIES.—For exempt commodities, the limits required under subparagraph (A) shall be established within 180 days after the date of the enactment of this paragraph.

‘‘(ii) AGRICULTURAL COMMODITIES.—For agricultural commodities, the limits required under subparagraph (A) shall be established within 270 days after the date of the enactment of this paragraph.

‘‘(C) GOAL.—In establishing the limits required under subparagraph (A), the Commission shall strive to ensure that trading on foreign boards of trade in the same commodity will be subject to comparable limits and that any limits to be imposed by the Commission will not cause price discovery in the commodity to shift to trading on the foreign boards of trade.

‘‘(3) SPECIFIC LIMITATIONS.—In establishing the limits required in paragraph (2), the Commission, as appropriate, shall set limits—

‘‘(A) on the number of positions that may be held by any person for the spot month, each other month, and the aggregate number of positions that may be held by any person for all months; and

‘‘(B) to the maximum extent practicable, in its discretion—

‘‘(i) to diminish, eliminate, or prevent excessive speculation as described under this section;

‘‘(ii) to deter and prevent market manipulation, squeezes, and corners;

‘‘(iii) to ensure sufficient market liquidity for bona fide hedgers; and

‘‘(iv) to ensure that the price discovery function of the underlying market is not disrupted.

Section 4a(a)(6) of the Commodity Exchange Act

‘‘(6) AGGREGATE POSITION LIMITS.—The Commission shall, by rule or regulation, establish limits (including related hedge exemption provisions) on the aggregate number or amount of positions in contracts based upon the same underlying commodity (as defined by the Commission) that may be held by any person, including any group or class of traders, for each month across—

‘‘(A) contracts listed by designated contract markets;

‘‘(B) with respect to an agreement contract, or transaction that settles against any price (including the daily or final settlement price) of 1 or more contracts listed for trading on a registered entity, contracts traded on a foreign board of trade that provides members or other participants located in the United States with direct access to its electronic trading and order matching system; and

‘‘(C) swap contracts that perform or affect a significant price discovery function with respect to regulated entities.

Section 4a(a)(7) of the Commodity Exchange Act

‘‘(7) EXEMPTIONS.—The Commission, by rule, regulation, or order, may exempt, conditionally or unconditionally, any person or class of persons, any swap or class of swaps, any contract of sale of a commodity for future delivery or class of such contracts, any option or class of options, or any transaction or class of transactions from any requirement it may establish under this section with respect to position limits.’’.

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Other related hedge fund law articles:

Cole-Frieman & Mallon LLP provides legal support and futures and commodities compliance services to all types of investment managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

CFTC Issues Report on NFA Registration Process

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Report Indicates Many Areas Needing Improvement

The CFTC registration process is handled almost exclusively by the NFA and last year the CFTC audited the NFA to see how successful the organization was at conducting the registration process.  The audit report, issued this week, indicates that the NFA needs to improve on many different areas.  One of the most important items which was mentioned a number of times in the report is that the NFA has not standardized the registration process in some areas.

While the CFTC report focuses only on the registration process, there are a number of other issues with the NFA which should have been highlighted.  The first and most important for many managed futures professionals, is the lack of standardization with respect to the disclosure document review process.  CTAs and CPOs both need to have their disclosure documents reviewed by the NFA and during this review process, depending on which examiner is assigned to the review, the process can be relatively straight-forward or quite difficult.  This obviously increases the time before the disclosure document is approved and most likely increases the legal costs involved.  Because our firm completes a number of CTA and CPO registrations each month we see this first hand.

As an anecdote, I have one CPO group who has two separate programs represented by two separate disclosure documents.  The documents are exactly the same except for slightly different investment programs.  These documents went to the NFA for review at the same time and were assigned to two different examiners.  Each deficiency letter came back with about 16 items that needed to be changed for the next draft – however, only 5 were the same!  The fact that two almost exactly same documents receive such disparate treatment is amazing and shows no standardization.  It also perfectly illustrates the oft said statement that “it depends on who you get” when discussing how long it will take for the disclosure documents to be approved.

Below I have included some of the statements I found in the report as well as the CFTC notice.

CFTC Notice: Press Release

The full report: CFTC Report on NFA Registration Process

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Quotes from the Report

The Registration Department does not have a procedures manual that documents all of the procedures followed in processing registrations and withdrawals.

The Registration Department’s procedures manual for the Information Center is, in various areas, incomplete, inconsistent and/or outdated.

[T]he Registration Department tends to concentrate responsibility in a small number of staff members and to depend heavily on these staff members’ institutional knowledge in executing certain registration processing procedures. … This reliance on key persons’ institutional knowledge, coupled with the sparseness of the Registration Department’s documented procedures … interjects an unnecessary level of key person risk to the Registration Department.

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June 24, 2010

CFTC Releases Report on the Registration Program of the NFA

Washington, DC – The Commodity Futures Trading Commission (CFTC) Division of Clearing and Intermediary Oversight (Division) today notified the National Futures Association (NFA) of the results of the Division’s “Report on the Registration Program of the NFA”. In the Report, the Division assessed whether the NFA has sufficient procedures to execute the Commission’s delegated registration and fitness functions.

The Division found that NFA has sufficient procedures to execute the Commission’s delegated functions with respect to the vast majority of registrants. However, the Division also identified nine areas in which the Commission’s and/or NFA’s procedures must be improved.

Copies of the Report are available the Commission’s website at www.cftc.gov.
Last Updated: June 24, 2010

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Cole-Frieman & Mallon LLP provides comprehensive hedge fund start up and regulatory support for commodity pool operators.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Federal Cap and Trade System and RPS Standards on the Horizon

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On June 5, 2010, the South Asian Bar Association hosted the 2010 NAPABA Western Regional Conference in San Francisco.  One panel, entitled “Green 2 Green: Carbon Credits, Renewable Energy Certificates and the New Markets Driving the Clean Energy Economy,” addressed the failure of existing markets to price carbon and other greenhouse gas (GHG) emissions and discussed the potential for market-based mechanisms to solve the problem.  This panel was particularly timely because of recent congressional discussion with respect to the EPA potentially regulating GHG.  Recently, the Senate failed to pass a resolution (47-53) blocking this regulatory authority under the Clean Air Act (for more information see this article).  The options are to have Congress or the EPA set the rules for emissions reduction.

The panel included representatives from the California Public Utilities Commission, Pacific Gas & Electric Company, and from a law firm.  In addition to discussing market-based mechanisms to promote renewable and clean energy, the panelists also informed the audience about GHG caps generally, carbon credits, renewable portfolio standards, and renewable energy certificates.

So why do we need market-based mechanisms?

The U.S. has traditionally relied heavily on fossil-fuel powered generating facilities.  These facilities provide cheap electricity for consumers, but at the expense of the environment.  Without a price for carbon emissions, there is no incentive to construct renewable energy facilities or to develop more clean energy sources.  The resulting consequences on our climate and economy are dire.  Many people believe that now is the time for federal and state governments to act and to develop the regulatory and market frameworks necessary to address this problem.

From a policy perspective, greater integration of renewable energy sources will:

  • increase the reliability of our power supply
  • protect public health and the environment
  • promote energy independence
  • promote economic efficiency
  • promote national security
  • promote the stability of electricity prices
  • promote the sustainability of economic development
  • create domestic jobs

Most interestingly, the panel discussed two key market-based mechanisms to promote renewable and clean energy: a cap and trade system and RPS goals.

What are the benefits of market-based mechanisms?

The discussion started with questions about the advantages of a cap and trade system and RPS goals over tax-based approaches and straight government mandates.  In particular, the issue is whether the public can trust new market-based mechanisms given the recent economic downturn.  The benefits of a cap and trade system are:

  • certainty as to the amount of reductions that occur,
  • flexibility for businesses to be innovative, and
  • flexibility for businesses to find the most cost-effective way to meet emissions limits, since policymakers do not always know what the lowest cost will be.

While the benefit of a carbon tax is price certainty, it is extremely difficult to determine what tax levels really reduce carbon emissions and encourage the construction of modern renewable energy facilities.  Generally, a carbon tax disincentivises the continued production of energy from traditional-fuel powered plants, but excessive taxes could also cripple economic development by unduly raising the cost of electricity and disproportionately impacting coal states.

Tax incentives, in contrast, are a great supplement to the new market-based mechanisms being developed.  Such incentives include accelerated depreciation, RECs, cash grants for renewable energy leases, production tax credits, and investment tax credits.  Policymakers need to focus on integrating a flexible cap and trade framework within a scheme of tax incentives that will ultimately result in low-cost solutions.

How does a cap and trade (carbon trading) system work?

Carbon trading is a market-based mechanism that reduces GHG emissions by allowing parties to trade emissions under a cap and trade system, or trade credits that pay for or offset GHG reductions.

For a carbon trading market to thrive, many argue that an emissions cap must be set by a governing body such as a regulatory or private agency.  The market-based framework then allows trading activity to take place.  The following are important elements:

  • The emissions cap should be decreased gradually to achieve real greenhouse gas reductions.
  • The market-based framework can function as an auction, a trading system, or a regulated market for participants to buy, sell or trade emissions allowances.
  • Proceeds can then be used to research and develop other energy efficiency and renewable energy (e.g., wind, solar, geothermal, biomass, etc.) solutions which helps companies meet their compliance obligations and spurs more investment opportunities.

What are RPS standards and how does it relate to carbon trading?

A renewable portfolio standard (RPS) generally refers to a regulation that encourages electric supply companies (such as PG&E) to produce a specific percentage of their electricity from renewable energy sources.  In California, for example, the RPS requirement is 20% by 2010.  Governor Schwartzeneggar also signed an executive order in 2008 mandating 33% by 2020.

When a certified renewable generator produces renewable electricity, it earns a certificate (REC) that can be sold along with the produced electricity to the supply company.  The supply company demonstrates its compliance with the RPS requirement with these RECs.  RPS compliance relies on the market and therefore allows more price competition based on factors such as renewable energy source type and project size.  This in turn results in more energy efficiency projects that produce renewable energy at the lowest cost–making it more competitive with cheaper, traditional fossil-fuel sources.

RPS requirements encourage the development of more renewable energy projects.  RECs can be traded or sold on the market and as companies reduce their GHG emissions, emissions allowances can also be made available on the market for trading.

Important Carbon Trading Frameworks and Legislation

Regional exchanges –important regional exchanges include:

Regional Greenhouse Gas Initiative (RGGI) – the RGGI is the first mandatory, market-based effort to reduce green house gas emissions in the United States.  The 10 participating states in the Northeastern and Mid-Atlantic states include Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, and Vermont.  Emissions allowances are sold through auctions and the target goal is to reduce CO2 emissions from the power sector 10% by 2018.

California – The California Air Resources Board, pursuant to AB 32, intends to develop a cap and trade system by 2012 for California.  AB 32 requires the reduction of GHG emissions to 1990 levels by the year 2020 and is similar to the Kyoto Protocol approach and standards.

Chicago Climate Exchange (CCX) – The CCX is a U.S.-based reduction and trading system.  Its participants include various major corporations including Ford, DuPont, and Motorola, as well as several universities including UC San Diego, Tufts University, Michigan State University, and University of Minnesota.  The CCX also supports renewable energy projects generated by offsets across North America and Brazil.  The Financial Industry Regulatory Authority (FINRA) acts as the independent, third party verification for the Chicago Climate Exchange even though the exchange is not regulated.  FINRA’s role is to verify and review emissions reports and offset projects, as well as monitor its trading activity.

Western Climate Initiative (WCI) – The WCI started in the western region of the United States and has spread across the United States and Canada.  Its U.S. partners include California, Montana, New Mexico, Oregon, Utah, and Washington, while its Canadian partners include British Columbia, Manitoba, Ontario, and Quebec.  Its observers include Alaska, Colorado, Idaho, Kansas, Nevada, and Wyoming, as well as various Mexican states.  The Initiative’s cap and trade proposal would help reduce carbon emissions from major sources of carbon emitters and also alleviate economic impacts on those regulated sources.  The program would begin in 2012.

Congressional Action

Currently, the federal government is actively working on energy issues, including the development of a cap and trade system.  The following summary is provided here to a comparison of the following legislation.

  • The Clean Energy Jobs and American Power Act (S. 1733 or CEJAPA or Power Act) was passed by the Senate Environment and Public Works Committee on November 5, 2009. This bill would create a federal GHG cap and trade system. The cap and trade program would be administered by the EPA and carbon market oversight would be delegated to the Commodity Futures Exchange Commission (CFTC) alone.
  • The American Clean Energy and Security Act of 2009 (HR 2454 or ACES) passed the House on June 26, 2009 by a vote of 219 to 212. ACES combines standards and incentives to promote clean energy and energy efficiency technologies with a firm cap on GHG emissions.  The cap and trade program would be administered by the EPA and deletes carbon market oversight to the Federal Energy Regulatory Commission and the CFTC.
  • The American Clean Energy Leadership Act (S. 1462 or ACELA) passed the Senate Energy and Natural Resources Committee on June 17, 2009 by a vote of 15 to 8. ACELA is an energy bill that incorporates many policies similar to those in ACES; the Senate is constructing a climate component to add to the bill, but currently ACELA does not include provisions to cap and trade greenhouse gas emissions. It does, however create federal RPS stnadards.

Cap and trade is not new.  What are some lessons learned?

As mentioned above, cap and trade is not new and the federal government is currently developing a cap and trade system, as evidenced in the Power Act.  The California Air Resources Board, pursuant to AB 32, intends to develop a cap and trade system by 2012 for California.  With all this legislative momentum, what are some of the lessons learned from the existing regional cap and trade frameworks mentioned above?

One panelist discussed the RGGI.  Unfortunately, the GHG prices are low because not all states connected to the grid participate in the program.  Power is therefore available outside of the RGGI framework and available at below-premium prices.  California needs to keep in mind that it can regulate prices within the state, but cannot regulate out-of-state power plants and the prices that are set.

Another panelist focused on the Clean Development Mechanisms of the Kyoto Protocol.  This mechanism encourages developed nations to invest in emissions reductions in developing nations.  But, as in any market-based system, one problem is gaming.  It is important that when the federal government develops a cap and trade system, it creates an infrastructure that guards against that possibility (e.g., ensure that third-party verification and certification processes are in place to ensure that reductions are legitimate).  Any cap and trade system must have built-in processes that preserve the integrity of the transactions that occur and the value of the underlying assets.

What does the future hold for the carbon trading market?

For the most part, the panelists seemed optimistic about a federal cap and trade system.  Regulatory uncertainty freezes markets and investments.  Once the government puts the appropriate regulatory framework in place, businesses are likely to have the confidence to make more investments, create more jobs, and spur the green economy.  While the federal government has unsuccessfully attempted to implement a cap and trade system in the past, this administration seems more receptive to passing comprehensive energy and climate legislation.

What will this mean for the carbon markets and as a result, the alternative investment industry?  If passed, the Power Act in its current form will allow entities to meet their emissions targets by submitting tradable emissions allowances.  It will grant the CFTC authority to regulate the GHG trading markets and amend the Commodity Exchange Act to regulate the trading of GHG instruments (including emission allowances, offset credits, and derivatives) in a manner similar to how agricultural commodities are regulated.  In particular, all trading of GHG instruments must take place on an exchange or be cleared through a carbon clearing organization.  Participation in the trading of allowances will be limited to CFTC-regulated carbon market participants and registered compliance entities.  Participants of derivative trading is not limited.  The Power Act would also prohibit short sales and sets position limits to prevent excessive speculation.  It is yet to be determined whether these provisions will restrict access to the market or adversely affect market liquidity.

The success of carbon trading in the investment management industry will depend greatly on the regulations put in place for the carbon markets.  It will be interesting to watch how the federal government and the CFTC work to create the framework for carbon and emissions trading.

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Cole-Frieman & Mallon LLP is able to provide the following legal services to both domestic and offshore hedge funds:

  • Offer investment advice to funds interested in the purchase of carbon offsets
  • Provide legal advice to clients in regards to carbon market regulations
  • Assist hedge funds with the creation of investment projects that generate carbon credits and offsets
  • Advise on marketing strategies for those clients interested in selling their carbon offsets or promoting their renewable energy projects
  • Provide networking opportunities with other lawyers engaged in the carbon market field
  • Advise clients on the policies and risks involved with credit trading

For more information, please call Bart Mallon Esq. at 415-868-5345.

CTA and CPO Registration Form 8-R Changes

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Fingerprint Information Now Required in Form 8-R

As discussed below, the information which is included on an AP or Principal’s Fingerprint Cards (sex, race, eye color, etc) will now be part of the NFA Form 8-R.  Additionally, the NFA will now make certain notifications to NFA member firms with respect to their application.

The full notice from the NFA is reprinted below.

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Fingerprint Card Demographic Information and Email Notifications Enhancements

The Spring 2010 NFA Member Newsletter reported an Online Registration System (ORS) enhancement that will require fingerprint card demographic information (such as sex, race, eye color, hair color, height and weight) be entered on the Form 8-R application. This enhancement is scheduled to be deployed on June 17, 2010. The fingerprint card demographic information is used to conduct a criminal background check with the U.S. Federal Bureau of Investigations (FBI). Because this information is already collected on the FBI fingerprint card, it may be helpful to have the fingerprint card available when completing the Form 8-R application.

Collecting this information in the Form 8-R applications will allow NFA to electronically submit fingerprint cards to the FBI in a timelier manner by downloading the fingerprint card demographic information directly from the 8-R form.

A view and update page are also being developed to display and update, if necessary, the fingerprint card demographic information. These pages can be accessed using the “View Registration Information” or “Update/Withdraw Registration Information” menu under the “Personal Profile” section.

For Form 8-R applications completed prior to the implementation of this enhancement, the demographic fields on the view and update pages will be blank. However, this information is not required to be completed until such time as a new Form 8-R application is filed.

In addition to the fingerprint card demographic information enhancement, we have also added two new notification types to the NFA E-mail Notification Service:

  1. Firm or Individual registered, temporary licensed, approved or conditioned
  2. Firm Account Balance is below $1000

The Security Manager of the firm can add the new notification types for existing email recipients or can add and/or delete recipient(s) to receive email notifications by clicking on “NFA E-mail Notification Service” under the “Security” tab in ORS.

If you have any questions concerning this matter, please contact the Information Center by phone at 312-781-1410 or 800-621-3570 or send an email to [email protected]. Representatives are available Monday through Friday from 8:00 a.m. to 5:00 p.m. CST.

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Cole-Frieman & Mallon LLP provides comprehensive hedge fund start up and regulatory support for commodity pool operators.  Bart Mallon, Esq. can be reached directly at 415-868-5345.