CFTC Proposes Additional Registration Requirements for Hedge Fund Managers

By David Mainzer

February 2011

This month, the Commodity Futures Trading Commission (the “CFTC”) announced that it is considering requiring a significant number of currently exempt hedge fund managers that trade in futures and commodity option products regulated by the CFTC to become “dual registrants.”   Dual registrants are required to register both as an investment adviser, with the Securities and Exchange Commission (the “SEC”), and as a commodity pool operator (a “CPO”), with the National Futures Association (the “NFA”).  The CFTC would accomplish this by eliminating two exemptions from the CPO registration requirements that are commonly used by hedge funds.

The following is a summary of certain parts of the proposed changes.  Note that these changes have not been enacted and the CFTC has not published a proposed timetable for their implementation.

CPO Exemptions

Currently, hedge fund managers may be exempt from registration as a CPO under one of two widely used exemptions: (a) the “limited trading exemption” under CFTC Rule 4.13(a)(3), which exempts managers of hedge funds that, among other things, limit the margin premiums required to establish the futures and commodity option positions to 5% of the fund’s net asset value; or (b) the “sophisticated investor exemption” under CFTC Rule 4.13(a)(4), which exempts managers of hedge funds that, among other things, require that each natural person investor in the hedge fund is a “qualified eligible person.”

As a result of the elimination of these two exemptions, many hedge fund managers that trade futures or commodity options, but are not currently required to be registered as CPOs, will be required either to register with the NFA as a CPO or else cease trading in these kinds of investments.

CTA Exemption

In addition to registration as a CPO, the manager of a hedge fund that trades in futures and commodity options is also subject to registration as commodity trading advisor (“CTA”) unless it comes within one of the exemptions from CTA registration.  Hedge fund managers that are exempt from CPO registration under the limited trading exemption and/or the sophisticated investor exemption are currently exempt from registering as CTAs under CFTC Rule 4.14(a)(8).  As a result, we expect that many hedge fund managers that are required to register as CPOs, because of the elimination of these two exemptions, will also be required to register as CTAs.

NFA Registration

Registration with the NFA (as a CPO and/or a CTA) is generally more time consuming and expensive than SEC registration as an investment adviser.  Hedge fund managers that register with the NFA are required to file Form 7-R for the manager and Form 8-R for each principal and associated person, and certain of the manager’s principals and other associated persons are required to pass the FINRA Series 3 examination.  The registration process can take 3 to 4 months.

Once registered as a CPO, the hedge fund manager becomes subject to the disclosure and reporting obligations in Part 4 of the CFTC Rules.  These include requirements that specific provisions must be included in the fund’s private placement memorandum, or otherwise disclosed to each investor, and acknowledged in writing by the investor.  The disclosure document must be filed with the CFTC and must be updated not less that once every nine months.  In addition, the CPO must provide specified annual reporting to investors and is subject to NFA/CFTC recordkeeping and regulatory examination requirements.

The CFTC is also currently proposing additional reporting requirements for CPOs that are dual registrants.  This is expected to include information about the hedge fund, including assets under management, use of leverage, counterparty exposure and trading and investment positions.  These requirements would be satisfied by filing Form PF with the SEC, with Part 1 due on an annual basis from CPOs with less than $1 billion under management, and Part 1 and 2 due on a quarterly basis from CPOs with more than $1 billion under management.

Conclusion

The CFTC has proposed to eliminate the limited trading exemption and the sophisticated investor exemption to CPO the registration requirements.  As a result, many hedge funds that trade futures or commodity options would be required to either register with the NFA as a CPO or else cease trading in these kinds of investments.  The CFTC has stated that the additional registration requirements are designed to limit regulatory arbitrage and increase transparency.  We expect that the elimination of these exemptions will, if enacted, aggravate the current increase in regulatory and compliance costs already impacting hedge funds.

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