Market Turmoil May Cause Fund Managers to Breach Commodity Pool Operator Exemption Thresholds

Both rules place strict limits on commodity interest trading. The current market turmoil caused in large part by the global COVID-19 pandemic has led to increased margin rates, increased options premiums, increased use of derivatives in general and declines in fund net asset values. Each of these effects may cause investment funds operating under these rules to breach the applicable trading limits, thereby triggering a CPO registration requirement and compliance with CFTC regulations applicable to CPOs, absent relief from the CFTC and/or NFA. Fund managers relying on Regulations 4.5(a)(1) or 4.13(a)(3) should carefully monitor their portfolios to ensure they continue to adhere to the trading limits. As of the date of this Sidley Update, the regulators have provided no relief, and it is uncertain whether they would be willing to consider relief in the near future. 

Regulation 4.5(a)(1)

Regulation 4.5(a)(1) excludes from the definition of CPO (i) an investment adviser that is registered with the Securities and Exchange Commission (SEC) and that operates an investment company that is registered as such or a business development company that has elected an exemption from registration under the Investment Company Act of 1940.  

A manager that relies on this exclusion must adhere to one or both of the de minimis trading thresholds described below with respect to each investment fund it operates pursuant to Regulation 4.5(a)(1), excluding commodity interest positions entered into for bona fide hedging purposes. The manager must also submit a notice of claim to NFA, affirm annually its claim, and adhere to certain marketing restrictions. Additional requirements are set forth in Regulation 4.5.

Regulation 4.13(a)(3)

Regulation 4.13(a)(3) exempts from CPO registration a manager with respect to its operation of any commodity pool that adheres to one or both of the de minimis trading thresholds described below, but without excluding commodity interest positions entered into for bona fide hedging purposes. The manager must also submit a notice of claim to NFA, affirm annually its claim, adhere to certain marketing and offering restrictions and limit participation in the pool to certain sophisticated investors. Additional requirements are set forth in Regulation 4.13.

The De Minimis Thresholds

A manager relying on either Regulation 4.5(a)(1) or Regulation 4.13(a)(3) must ensure that the relevant investment fund satisfies one or both of the following tests at all times:

1. The 5 Percent Test: The aggregate initial margin and premiums required to establish commodity interest positions must not exceed 5 percent of the “liquidation value” of the pool’s portfolio.
2. The 100 Percent Test: The aggregate “net notional value” of commodity interest positions may not exceed 100 percent of the “liquidation value” of the pool’s portfolio.

• “Notional value” must be calculated as follows:
  • Futures: {Number of contracts} x {Size of contract (in contract units and taking into account any contract multiplier)} x {current market price per unit}
  • Options: {Number of contracts} x {Size of contract (adjusted by delta, in contract units, and taking account of any contract multiplier} x {strike price per unit}
  • Retail forex: Value in U.S. dollars at the time the transaction was established but excluding the value in U.S. dollars of offsetting long and short transactions
  • Cleared swaps: Value as determined consistent with Part 45 of the CFTC’s regulations
  • Uncleared swaps: Amount reported by the reporting counterparty as the notional amount of the swap under Part 45 of the CFTC’s regulations.
• Netting of notional values — only the following netting is allowed:
  • Futures with the same underlying commodity may be netted across designated contract markets (DCMs) and foreign boards of trade
  • Commodity options with the same underlying may be netted across DCMs and foreign boards of trade
  • Cleared swaps may be netted when cleared at the same derivatives clearing organization “where appropriate”
  • Uncleared swaps may not be netted, even if they are entered into with a single counterparty and subject to a netting agreement.

Unrealized profits and losses — In calculating the 5 percent and 100 percent tests, the manager must take into account unrealized profits and unrealized losses on commodity interest positions. In the case of the 5 percent test, for an option that is in-the-money when purchased, the in-the-money amount may be excluded.

Timing — Either the 5 percent or 100 percent test (or both) must be satisfied “at all times.” The CFTC staff has interpreted this to mean that the fund is only required to satisfy one or both of the trading limits at each time a commodity interest position is established. For pools that transact in commodity interests frequently, this may require almost constant monitoring. Fund managers may put in place automated systems capable of monitoring one or both tests in real time, but some managers monitor compliance with the trading limits manually. Importantly, a pool is not required to exit a commodity interest position if it has exceeded an applicable trading limit due to changes in its portfolio not caused by establishing a commodity interest position. For example, if a fund “drifts” over the limits due to a decrease in the value of its portfolio, it is not required to exit positions. However, it may only be able to trade out of commodity interest positions until it comes back into compliance with the trading limits.  

The CFTC staff has indicated that CPOs relying on Regulation 4.13(a)(3) “should have a reasonable time to comply with the required trading thresholds” but has refused to provide a bright line test for what is a “reasonable time,” indicating that it depends on the facts and circumstances. The same leeway would seem to apply to managers relying on Regulation 4.5(a)(1). This statement from the CFTC staff was made in the context of a pool that enters into a swap transaction as its first transaction and therefore is out of compliance with the trading thresholds temporarily at the beginning of its life. It is not clear whether the staff would agree that a fund that breaches the trading thresholds during its lifetime for a “reasonable time” and then gets back into compliance with the trading limits would be afforded the same leeway.

Liquidation value — In most instances, the “liquidation value” of a fund’s portfolio is merely the fund’s net asset value.

Hedging — The 5 percent and 100 percent tests under Regulation 4.5 disregard commodity interest positions entered into for bona fide hedging purposes. Pools operated under Regulation 4.13(a)(3) are not allowed to exclude positions entered into for bona fide hedging purposes. 

COVID-19

The markets, including the commodity interest markets, are undergoing unprecedented volatility caused in large part by the COVID-19 pandemic. Absent regulatory relief, advisers and CPOs that rely on either Regulation 4.5(a)(1) or 4.13(a)(3) must continue to adhere to the trading limits described above or face the potential risk of being required to become registered with the CFTC as a CPO. 

This may be challenging for several reasons:

• Increases in market volatility generally cause increases in margin levels with respect to commodity interest positions. The same may be true of options premiums, the level of which is driven in part by market volatility. In either case, this will increase the numerator under the 5 percent test and make it more difficult to satisfy that test.
• Fund managers may have an increased need to use commodity interests to manage their portfolios in this market — both more positions and larger positions. Any increase in the use of commodity interests will lead to an increase in initial margin, options premiums and notional values. This leads to corresponding increases in the numerator under both the 5 percent and 100 percent tests, making it more difficult to satisfy either test.
• The significant devaluation of investment instruments in many markets may cause a fund’s net asset value (i.e., the liquidation value of the fund’s portfolio) to decrease. Any decrease in net asset value, which is the denominator for both the 5 percent and 100 percent tests, will make it more difficult to satisfy either test. 

²See Sidley Update, Pandemic-Related Relief Announced by U.S. Commodity Futures Trading Commission and National Futures Association (March 19, 2020), available at https://www.sidley.com/en/insights/newsupdates/2020/03/us-commodity-futures-trading-commission-and-national-futures-association-issue-covid-19.