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Pages home > Must Hedge Funds Register as Commodity Pool Operators?

Must Hedge Funds Register as Commodity Pool Operators?

If your fund will trade in futures contracts, commodity options (including options on futures contracts), leverage contracts involving certain precious metals, or futures contacts and commodity options traded on a board of trade, exchange or market located outside the United States ("foreign futures" and "foreign options"), you are subject to regulation and registration as a Commodity Pool Operator (CPO) and your fund is a commodity pool (Pool). If your fund trades "spot currency" it is not a Pool and you don't need to register as a CPO. However, if your currency trades don't settle by the second business day after they are opened, your fund may be trading foreign currency commodities and options and be classified as a Pool. Moreover, a fund that does not itself trade in futures contracts or commodity options but invests in commodity pools is itself a Pool (as well as a fund of fund). A modest level of commodity trading can result in a commodity pool.

Bad News: The very breadth of the definition of a Pool is a trap for the unwary.

Good News : Regulations adopted in 2003 exempt from registration CPOs operating qualifying Pools.

If you can't take advantage of an exemption from registration (see below) under regulations issued by the Commodity Futures Trading Commission (CFTC), you must register with the CFTC, join the National Futures Association (NFA), and absent CFTC regulatory relief, comply with detailed disclosure, recordkeeping and reporting regulations.

A modest level of commodity trading can result in a commodity pool. The good news is that regulations adopted in 2003 exempt from registration CPOs operating qualifying Pools.

Regulation of Commodity Pool Operators (CPOs) The NFA is a self-regulatory organization to which the CFTC has delegated certain registration functions, including the registration of CPOs. In the case of Pools, the operator of the Pool rather than the Pool itself is subject to registration. A CPO that sets up an exempt Pool (see below) is exempt from NFA registration, does not have to take the Series 3 exam, or become a member of the NFA. A CPO may also have to comply with provisions of the Model State Commodity Code, or other comparable law within a particular state.

To become a CPO, you must pass the Series 3 Exam (National Commodity Futures Examination). No sponsor is needed for the exam, and those taking the exam generally follow a program of self-study. You must file a Form 7-R for the Pool and a Form 8-R for each principal and associated person of the CPO. Each application requires the payment of a registration fee and an annual fee. Processing an application can require about 2 or 3 months, although applications can be processed in significantly shorter periods.

Offering and Disclosure Documents Absent an applicable exemption, a CPO must register with the NFA and provide prospective investors with all material information about the Pool. Information is provided to potential investors in a disclosure document (or "DD" for short) at the time it delivers a subscription agreement. The DD can be delivered electronically and is filed with the NFA at least 21 days before distribution.

DD's typically include the following:

  • Private placement memorandum (PPM),
  • Investor Questionnaire and Subscription agreement; and
  • Limited Partnership Agreement for the Pool.

The PPM must include:

  • Information about the Pool, the CPO and its Principals/Organizers,
  • Disclosure of Risk Factors;
  • Description of the Pool trading strategy- categorized by market sector, type of commodity, trading restrictions, procedures regarding use of margin payments, the name of the trading custodian, and the name of the Pool's FCM or IB;
  • Historical Performance Data (current to within 3 months) for all other Pools operated by the CPO or its trading manager, or a statement in a CFTC prescribed format that the CPO does not have a performance history;
  • Fees;
  • Professional and disciplinary history of the CPO and the Pool's trading manager;
  • Disclose Conflicts of Interest; and
  • Contain Cautionary and Risk Disclosure Statements.

The DD must be updated at least every 9 months. Along with the DD, a CPO must provide prospective investors with the Pool's annual report and performance information of the Pool current to within the past 60 days.

If you plan to have investors who are not "accredited" in the Pool, you will need not only a DD, but also a set of audited financials at the outset documenting the source of initial capital invested in the Pool. This initial audit is referred to as a "launch audit" or as a "seed capital audit." It is a good idea to obtain a launch audit in any event.

Accredited Investor . For those unfamiliar with the distinction between accredited and non- accredited investors, generally, accredited investors are persons whose net worth (or joint net worth with that person's spouse) exceeds $1,000,000, or whose income was in excess of $200,000 in each of the two preceding years (or, together with that person's spouse, in excess of $300,000 in each of the two preceding years), and who reasonably expects to reach the same level of income in the current year.

Any investor who is not an "accredited investor" must have sufficient knowledge and experience in financial and business matters to be able to evaluate the merits and risks of a Pool. Taking on non- accredited investors is risky from the standpoint of a CPO. If there are ever any problems with the Pool's performance, a court or arbitration board would probably side with the non-accredited investor in the event of a dispute.

State Registration . States that have adopted the Model State Commodity Code requiring Pools to be registered impose qualification requirements on sponsors, impose investor suitability requirements, limit fees, compensation and expenses paid by a Pool, mandate certain rights for investors as to reporting, set standards of fiduciary obligations owed to investors, and impose marketing, disclosure and other obligations.

Can I Avoid NFA Registration? The CFTC provides for key exemptions from the CPO registration requirements if all Pool investors meet a certain sophistication level. A CPO that sets up an exempt Pool and is exempt from NFA registration does not have to take the Series 3 exam or become a member of the NFA.

Single Pool Exemption. The Single Pool Exemption is available to a CPO who operates only one pool at a time and does not receive any direct or indirect compensation other than reimbursement of expenses. No one involved in the Pool can advertise the Pool or systematically solicit investors.

Small Pool Exemption. The Small Pool Exemption is available to a CPO receiving capital contributions of less than $400,000 if the Pool doesn't have more than 15 investors. The CPO and its principals and certain relatives of the principals are not counted toward the 15 investor limit. Moreover, their contributions do not count toward the $400,000 limit.

Limited Futures Trading Exemption. The Limited Futures Trading Exemption is available to a CPO of a Pool in which futures trading is limited to 5% of the net liquidation value of the Pool or the net notional value of futures and commodity positions does not exceed 100% of the net liquidation value of the Pool. Computing notional value is complex under CFTC Regulation Section 4.13(a) and the Pool must be limited to accredited investors under Regulation D.

Qualifying Investors Exemption. The Qualifying Investors Exemption is available to a CPO of a Pool where each "natural person" investor is a "qualified eligible person" or an accredited investor. Interests in the Pool must be exempt from registration under Regulation D and the Securities Act of 1933 and interest must be sold without marketing to the public.

Taking Advantage of the CFTC's Registration Exemptions To use these exemptions, the CPO must provide to investors at the time it delivers the subscription agreement to investors a:

  • copy of the NFA exemption letter, as filed with the NFA; and
  • a statement that it is not required to deliver a DD or a certified annual report (even though most Pools provide these materials to its investors).

The CPO relying on these exemptions must keep books and records and make them available for inspection by the CFTC upon request.

Registering as an Investment Adviser You do not have to register as an investment adviser if you are not trading securities. Commodities and futures are not securities. If you plan to execute more than an occasional stock trade, however, you may have to register as an investment adviser. Security futures products also constitute securities for purposes of the Investment Company Act of 1940 and CPOs of Pools that trade such products are subject to its constraints.

Why Do I Have to File Form D with the SEC? Regulation of a CPO by the CFTC does not exempt either the CPO or the Pool from regulation by the SEC. Interests in a Pool are securities and U.S. securities laws apply to Pools and their managers. If the Pool is not structured to fall within the private placement exemption of Regulation D, interests in the Pool would need to be registered. It is also important to know that security futures products also constitute securities for purposes of the Investment Company Act of 1940 and Pools that trade such products are subject to its constraints.

Most Pools are sold as private placements under Regulation D and Form D is filed with the SEC. State blue sky rules still apply to Pool relying on Regulation D (or the private placement exemption under the Securities Act of 1933) and state forms (generally, Form U-2 and Form U-2A) are filed as well.

Resources on the NFA Web Site The NFA's Web site is an excellent resource for prospective CPOs. The following links may be particularly helpful.

1. The home page for the National Futures Association – the NFA .

2. http://www.nfa.futures.org/compliance/issues_cpo_cta.asp and http://www.nfa.futures.org/compliance/publications/dd2001/DD2004.pdf – These Web pages are related to the NFA's Guidance to Commodity Pool Operators. The second link is particularly valuable. It essentially defines the sections that need to be included with a CPO document that is submitted to the NFA. It also discusses some of the various exemptions from registration that are available.

3. http://www.nfa.futures.org/registration/cpo.asp – The NFA's guidance on registering as a CPO—who is required to do so, and how it is accomplished. It includes a link to a page for an "Easy Reference Guide" to exemptions from registration: http://www.nfa.futures.org/registration/easyReferenceGuidePart4.pdf.

4. http://www.nfa.futures.org/registration/nfa_membership.asp – Data related to becoming a member of the NFA.

5. http://www.nfa.futures.org/basicnet – This page gives you access to a summary of the status of all NFA members, including regulatory status and sanctions.

6. http://www.cftc.gov/cftc/cftclawreg.htm#cea – This is an invaluable site to review the underlying federal law related to CFTC issues. Note the various links in the body of the page as well as on the left navigation buttons.

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Last updated 2546 days ago by Capital Management Services Group