CFTC Also Proposes Amendments to Help Non-U.S. CPOs and Extends its Uncleared Swap Margin Phase-In Schedule

During the period from late May 2020 through early June 2020, the Commodity Futures Trading Commission held several open meetings at which it addressed a number of issues pertinent to buy-side commodity interest market participants. These developments include: a final rule that applies statutory disqualification prohibitions to exempt commodity pool operators (CPOs); a proposed rule that would expand the usefulness of a common CPO registration exemption on which many non-U.S. CPOs rely; and an interim final rule to bypass September 1, 2020 as a phase-in date for the CFTC uncleared swap initial margin requirements. Each of these developments is significant to a different portion of the participants in the buy-side of the market. This Dechert OnPoint addresses these developments in turn.

CFTC Finalizes New Requirement Applying Statutory Disqualification Prohibitions to CPOs Exempt under CFTC Regulation 4.13 – Exempt CPOs Must Take Action in 2020

The CFTC on June 4, 2020 unanimously approved an important final amendment to Regulation 4.13 under the Commodity Exchange Act (CEA).¹ This amendment adds a new requirement that any person filing with the National Futures Association (NFA) a notice of exemption from registration as a CPO under Regulation 4.13(a)(1), (2), (3) or (5), or annually affirming such an exemption, must make a specified representation. The representation will provide that neither the person, nor any of the person’s principals, has in its background a statutory disqualification that would require disclosure under Section 8a(2) of the CEA if such person sought registration (unless such disqualification arises from a matter disclosed in connection with a previous application for registration, where such registration was granted).² The CFTC definition of a “principal” is set forth in its entirety in the appendix to this OnPoint.

Section 8a(2) sets forth the offenses for which the CFTC, upon notice but without a hearing, may “refuse to register, [] register conditionally, or [] suspend or place restrictions upon the registration of, any person.”³ This section also allows the CFTC to revoke the registration of any person with such a hearing as may be appropriate. Section 8a(2) is set forth in its entirety in the appendix to this OnPoint.

The Adopting Release highlights that, prior to this rulemaking, generally CPOs had not been able to register with the CFTC and their principals had not been able to register or be listed with the NFA in connection with that registration, if either had the Section 8a(2) statutory disqualifications. However, CPOs operating in reliance on Regulation 4.13 had not been subject to such a restriction. The Adopting Release states that with the Regulation 4.13 amendment, the CFTC seeks “to close that regulatory gap by effectively prohibiting any person who has, or whose principals have, in their background” a Section 8a(2) statutory disqualification from claiming a CPO exemption under Regulation 4.13.

In addition to the exception provided in the text of the Regulation 4.13 amendment, the Adopting Release indicates that a person with a Section 8a(2) statutory disqualification could seek individual exemptive relief from the CFTC, as “there may be facts and circumstances, pursuant to which permitting such disqualified CPOs and principals to operate exempt commodity pools may not be inconsistent with the Commission’s customer protection concerns.” Such CPOs may seek exemptive letter relief from the representation requirement “by presenting the facts and legal rationale demonstrating that such exemptive letter relief would be consistent with the public interest and not contrary to the specific purposes of CFTC Regulation 4.13(b)(1), i.e., providing some customer protection to exempt pool participants.”

The Adopting Release further states that such grants of relief will be infrequent, and must be supported by “a strong factual and legal basis so as to avoid undermining the purposes” of the Regulation 4.13 amendment. The Adopting Release also highlights that a person that is unsuccessful in a request for exemptive relief could at any point submit an application for CPO registration.

The CFTC’s application of the Section 8a(2) statutory disqualifications to Regulation 4.13 exempt CPOs and their principals will require such exempt CPOs to develop and implement a process to: classify all applicable individuals and entities as principals or not; conduct background checks on the identified principals; and indicate whether any identified principals are subject to a Section 8a(2) statutory disqualification. This likely will create significant new compliance costs for the affected CPOs.

For new claims of exemption from CPO registration, the effective date of this rulemaking will be September 8, 2020. CPOs currently relying on a Regulation 4.13 exemption will need to come into compliance by March 1, 2021, which coincides with the end of the annual reaffirmation period for CPOs operating under the Regulation 4.13 exemptions. Given that the steps to come into compliance may be time-consuming, exempt CPOs should begin the process of identifying their principals and conducting diligence to confirm the lack of Section 8a(2) statutory disqualifications for the firm and its principals.

CFTC Proposes Amendments to CFTC Regulation 3.10(c)(3) to Benefit Non-U.S. CPOs

The CFTC voted unanimously at its May 28, 2020 open meeting to approve proposed amendments to Regulation 3.10(c)(3), which would expand the availability of the CPO registration exemption with respect to persons located outside of the United States that are engaged in CPO activities.⁴ Currently, Regulation 3.10(c)(3) provides a self-executing registration exemption to a CPO that is located outside the United States, its territories or possessions, and which operates an offshore commodity pool whose investors also are all located outside the United States, its territories or possessions. In order for the CPO to qualify for this registration exemption, the commodity pool may be trading commodity interests on U.S. exchanges or with U.S. counterparties. This CPO registration exemption has been helpful to non-U.S. CPOs wanting to trade in U.S. commodity interest markets, but not offering any of their funds to U.S. investors. However, as CPOs’ businesses have evolved and developed, the simplicity of the Regulation 3.10(c)(3) exemption has raised several questions with which market participants have had to grapple, because the exemption does not address some of the more complex situations in which non-U.S. CPOs find themselves.

The proposed amendments would seek to provide clarification regarding the use of the exemption in various common circumstances. Specifically, the proposal would: (1) amend the exemption so that non-U.S. CPOs could rely on the exemption on a pool-by-pool basis to better reflect the fact that many non-U.S. CPOs have commodity pools that they offer to U.S. persons and other commodity pools that they offer exclusively to non-U.S. persons; (2) add a conditional safe harbor for non-U.S. CPOs that may be unable to verify that a pool has only non-U.S. participants; (3) amend the exemption so that it could be utilized concurrently with other exemptions or exclusions generally available to CPOs; and (4) provide an exception for initial capital contributions (seeding) received from a controlling affiliate of an offshore pool’s non-U.S. CPO.

In the proposal, the CFTC affirmed its belief that the Commission’s time and resources should focus on the consumer protection activities of U.S. persons, as well as the entities that solicit commodity interest transactions from those persons. Accordingly, the Commission is proposing amendments to Regulation 3.10(c)(3) intended to reduce regulation of non-U.S. CPOs operating commodity pools located outside the United States that have only non-U.S. participants. The proposal would permit a non-U.S. CPO to rely on Regulation 3.10(c)(3) on a pool-by-pool basis, by specifying that the availability of the exemption would be determined by whether all of the participants in a particular offshore pool are located outside of the United States, its territories and possessions, rather than looking at whether the non-U.S. CPO offers any of its pools to U.S. persons. As a result of this pool-by-pool approach rather than the firm approach to qualification, Regulation 3.10(c)(3) would permit a non-U.S. CPO to rely upon the exemption for the offshore pools it operates with solely non-U.S. participants, while concurrently operating the commodity pools the CPO offers to U.S. persons under the various CFTC Part 4 registration and operational exemptions.

The proposed amendments to Regulation 3.10(c)(3) also would include a safe harbor to enable non-U.S. CPOs to avail themselves of the exemption even when, by virtue of the structure of their operated pools, they cannot with certainty represent that there are no U.S. participants in the pools. The CFTC opted to add this safe harbor as an acknowledgment that due to the nature of some offshore commodity pools, it may be difficult for a CPO to ensure that all investors are non-U.S. persons, even if the pool is neither intended for nor marketed to U.S. persons. In order to qualify for the safe harbor, the following conditions would need to be met:

• The non-U.S. pool’s offering materials and any distribution agreements would need to include clear, written prohibitions on offering to, and ownership by, U.S. persons;
• The pool’s governing and offering documents would need to be reasonably designed to preclude U.S. persons from participating therein, and include mechanisms reasonably designed to enable the non-U.S. CPO to exclude any U.S. persons attempting to participate in the pool;
• The non-U.S. CPO would need to use exclusively non-U.S. intermediaries to distribute interests in the pool;
• The non-U.S. CPO would need to employ reasonable investor due diligence methods to preclude U.S. persons from participating; and
• Interests in the pool would need to be directed and distributed to participants outside the United States, including by means of listing and trading on secondary markets organized and operated outside of the United States, and in which the non-U.S. CPO has reasonably determined that participation by U.S. persons is unlikely.

Importantly, the non-U.S. CPO would be expected to keep adequate records showing compliance with the above conditions. The addition of this safe harbor should help non-U.S. CPOs with some of the screening issues they experience when trying to ensure that non-U.S. persons do not participate in their funds, especially where those funds are traded in secondary markets such as on exchanges.

Further, the proposed amendments would allow a non-U.S. CPO to qualify for the Regulation 3.10(c)(3) exemption where it has received initial capital contributions into an offshore pool from a U.S. person controlling affiliate⁵ of the pool’s non-U.S. CPO, subject to certain limitations intended to limit the possibility of evasion. This provision will allow U.S. affiliates of non-U.S. CPOs to “seed” funds with U.S. capital while still allowing the non-U.S. CPO to qualify for Regulation 3.10(c)(3). The exception is limited to contributions to the pool at or near its inception, although the U.S.-affiliate’s seed money may remain in the pool.⁶

The CFTC staff noted that the amendments under consideration are intended to provide much-needed regulatory flexibility for non-U.S. CPOs operating offshore pools, by taking into account the global nature of their operations without compromising the CFTC’s mission of protecting U.S. pool participants. The CFTC is seeking comment on all aspects of the proposal, including specifically, potential additional conditions to the controlling affiliate investment exception that are designed to prevent potential evasion of the CFTC’s general CPO compliance requirements. Comments are due to the CFTC by August 11, 2020.

CFTC Delays September 2020 Uncleared Swap Initial Margin Phase-In Date Due to COVID-19 Pandemic; U.S. Prudential Regulators Follow Suit

At its open meeting on May 28, 2020, the CFTC also voted unanimously to approve an interim final rule that extends the compliance schedule for the CFTC’s Dodd-Frank initial margin requirements for uncleared swaps in response to the COVID-19 pandemic; this extension effectively bypasses September 1, 2020 as a phase-in date for the requirements. The Dodd-Frank initial margin requirements mandate parties meeting certain thresholds of uncleared swap exposure to post initial margin to each other. That initial margin must be segregated and held by a custodian. If parties will be subject to the Dodd-Frank initial margin requirements, a significant number of agreements must be negotiated ahead of time and various complex systems must be put in place. In addition, to the extent that a counterparty would not have required initial margin for an uncleared swap for credit reasons, the margin mandated by regulation would tie up assets. Further, because initial margin mandated by regulation would be required to be segregated, parties to the swap would not be able to rehypothicate the collateral, thereby creating an opportunity cost on possible additional returns.

Compliance with the CFTC’s Dodd-Frank initial margin requirements originally were scheduled to be phased-in between September 1, 2016 and September 1, 2020, based on each party’s notional amount of uncleared derivatives. Currently, the amount of material swap exposure that a swap counterparty will need in order to be required to post initial margin for uncleared swaps is $750 billion of average daily aggregate notional value (AANA).⁷ Due to the disruptions that the COVID-19 coronavirus has caused in the markets, September 1, 2020 will no longer serve as a phase-in compliance date. Instead, under the CFTC's interim final rule, on September 1, 2021, such amount will be $50 billion of AANA. In addition, at an open meeting that the CFTC held on June 25, 2020, the CFTC voted to propose a rulemaking that would establish a new sixth (and final) phase of compliance, at a level of $8 billion of AANA, and set September 1, 2022 as a new compliance date for the sixth phase.

On that same day, the U.S. Prudential Regulators⁸ announced an interim final rule that will delay to September 1, 2021 the compliance date for uncleared swap counterparties with AANA of $50 billion.⁹ The U.S. Prudential Regulators’ interim final rule goes further than the CFTC final interim rule in that the latter establishes a new sixth phase of compliance, at a level of $8 billion of AANA, with a compliance date of September 1, 2022. It is important that the U.S. Prudential Regulators’ requirements align with the CFTC’s because many registered swap dealers also are subject to prudential regulation. In order for the CFTC’s extensions to be effective for the market, the U.S. Prudential Regulators needed at least to match the CFTC’s actions, if not exceed them.

Appendix

CFTC Regulation 3.1(a) – Definition of a Principal

(a) Principal. Principal means, with respect to an entity that is an applicant for registration, a registrant or a person required to be registered under the CEA or the regulations in this part:

(1) If the entity is organized as a sole proprietorship, the proprietor and chief compliance officer; if a partnership, any general partner and chief compliance officer; if a corporation, any director, the president, chief executive officer, chief operating officer, chief financial officer, chief compliance officer, and any person in charge of a principal business unit, division or function subject to regulation by the Commission; if a limited liability company or limited liability partnership, any director, the president, chief executive officer, chief operating officer, chief financial officer, chief compliance officer, the manager, managing member or those members vested with the management authority for the entity, and any person in charge of a principal business unit, division or function subject to regulation by the Commission; and, in addition, any person occupying a similar status or performing similar functions, having the power, directly or indirectly, through agreement or otherwise, to exercise a controlling influence over the entity's activities that are subject to regulation by the Commission;

(2)(i) Any individual who directly or indirectly, through agreement, holding company, nominee, trust or otherwise, is either the owner of ten percent or more of the outstanding shares of any class of equity securities, other than non-voting securities, is entitled to vote or has the power to sell or direct the sale of ten percent or more of the outstanding shares of any class of equity securities, other than non-voting securities, is entitled to receive ten percent or more of the profits of the entity, or has the power to exercise a controlling influence over the entity's activities that are subject to regulation by the Commission; or

(ii) Any person other than an individual that is the direct owner of ten percent or more of the outstanding shares of any class of equity securities, other than non-voting securities; or

(3) Any person that has contributed ten percent or more of the capital of the entity, provided, however, that if such capital contribution consists of subordinated debt contributed by either:

(i) An unaffiliated bank insured by the Federal Deposit Insurance Corporation,

(ii) An unaffiliated “foreign bank,” as defined in 12 CFR 211.21(n) that currently operates an “office of a foreign bank,” as defined in 12 CFR 211.21(t), which is licensed under 12 CFR 211.24(a),

(iii) Such unaffiliated office of a foreign bank that is licensed, or

(iv) An insurance company subject to regulation by any State, such bank, foreign bank, office of a foreign bank, or insurance company will not be deemed to be a principal for purposes of this section, provided such debt is not guaranteed by another party not listed as a principal.

(4) Any individual who, directly or indirectly, creates or uses a trust, proxy, power of attorney, pooling arrangement or any other contract, arrangement, or device with the purpose or effect of divesting such person of direct or indirect ownership of an equity security of the entity, other than a non-voting security, or preventing the vesting of such ownership, or of avoiding making a contribution of ten percent or more of the capital of the entity, as part of a plan or scheme to evade being deemed a principal of the entity, shall be deemed to be a principal of the entity.

Section 8a(2)

The Commission is authorized—upon notice, but without a hearing and pursuant to such rules, regulations, or orders as the Commission may adopt, to refuse to register, to register conditionally, or to suspend or place restrictions upon the registration of, any person and with such a hearing as may be appropriate to revoke the registration of any person—

(A) if a prior registration of such person in any capacity has been suspended (and the period of such suspension has not expired) or has been revoked;

(B) if registration of such person in any capacity has been refused under the provisions of paragraph (3) of this section within five years preceding the filing of the application for registration or at any time thereafter;

(C) if such person is permanently or temporarily enjoined by order, judgment, or decree of any court of competent jurisdiction (except that registration may not be revoked solely on the basis of such temporary order, judgment, or decree), including an order entered pursuant to an agreement of settlement to which the Commission or any Federal or State agency or other governmental body is a party, from (i) acting as a futures commission merchant, introducing broker, floor broker, floor trader, commodity trading advisor, commodity pool operator, associated person of any registrant under this chapter, securities broker, securities dealer, municipal securities broker, municipal securities dealer, transfer agent, clearing agency, securities information processor, investment adviser, investment company, or affiliated person or employee of any of the foregoing or (ii) engaging in or continuing any activity where such activity involves embezzlement, theft, extortion, fraud, fraudulent conversion, misappropriation of funds, securities or property, forgery, counterfeiting, false pretenses, bribery, gambling, or any transaction in or advice concerning contracts of sale of a commodity for future delivery, concerning matters subject to Commission regulation under section 6c or 23 of this title, or concerning securities;

(D) if such person has been convicted within ten years preceding the filing of the application for registration or at any time thereafter of any felony that (i) involves any transactions or advice concerning any contract of sale of a commodity for future delivery, or any activity subject to Commission regulation under section 6c or 23 of this title, or concerning a security, (ii) arises out of the conduct of the business of a futures commission merchant, introducing broker, floor broker, floor trader, commodity trading advisor, commodity pool operator, associated person of any registrant under this chapter, securities broker, securities dealer, municipal securities broker, municipal securities dealer, transfer agent, clearing agency, securities information processor, investment adviser, investment company, or an affiliated person or employee of any of the foregoing, (iii) involves embezzlement, theft, extortion, fraud, fraudulent conversion, misappropriation of funds, securities or property, forgery, counterfeiting, false pretenses, bribery, or gambling, or (iv) involves the violation of section 152, 1001, 1341, 1342, 1343, 1503, 1623, 1961, 1962, 1963, or 2314, or chapter 25, 47, 95, or 96 of title 18, or section 7201 or 7206 of title 26;

(E) if such person, within ten years preceding the filing of the application or at any time thereafter, has been found in a proceeding brought by the Commission or any Federal or State agency or other governmental body, or by agreement of settlement to which the Commission or any Federal or State agency or other governmental body is a party, (i) to have violated any provision of this chapter, the Securities Act of 1933, the Securities Exchange Act of 1934, the Public Utility Holding Company Act of 1935, the Trust Indenture Act of 1939, the Investment Advisers Act of 1940, the Investment Company Act of 1940, the Securities Investors Protection Act of 1970, the Foreign Corrupt Practices Act of 1977, chapter 96 of title 18, or any similar statute of a State or foreign jurisdiction, or any rule, regulation, or order under any such statutes, or the rules of the Municipal Securities Rulemaking Board where such violation involves embezzlement, theft, extortion, fraud, fraudulent conversion, misappropriation of funds, securities or property, forgery, counterfeiting, false pretenses, bribery, or gambling, or (ii) to have willfully aided, abetted, counseled, commanded, induced, or procured such violation by any other person;

(F) if such person is subject to an outstanding order of the Commission denying privileges on any registered entity to such person, denying, suspending, or revoking such person’s membership in any registered entity or registered futures association, or barring or suspending such person from being associated with a registrant under this chapter or with a member of a registered entity or with a member of a registered futures association;

(G) if, as to any of the matters set forth in this paragraph and paragraph (3), such person willfully made any materially false or misleading statement or omitted to state any material fact in such person’s application or any update thereto; or

(H) if refusal, suspension, or revocation of the registration of any principal of such person would be warranted because of a statutory disqualification listed in this paragraph:

Provided, That such person may appeal from a decision to refuse registration, condition registration, suspend, revoke or to place restrictions upon registration made pursuant to the provisions of this paragraph in the manner provided in section 9 of this title; and

Provided, further, That for the purposes of paragraphs (2) and (3) of this section, “principal” shall mean, if the person is a partnership, any general partner or, if the person is a corporation, any officer, director, or beneficial owner of at least 10 per centum of the voting shares of the corporation, and any other person that the Commission by rule, regulation, or order determines has the power, directly or indirectly, through agreement or otherwise, to exercise a controlling influence over the activities of such person which are subject to regulation by the Commission.

Footnotes

1) Registration and Compliance for Commodity Pool Operators and Commodity Trading Advisors: Prohibiting Exemptions on Behalf of Persons Subject to Certain Statutory Disqualifications, 85 Fed. Reg. 40877 (July 8, 2020) (Adopting Release).

2) Note, however, that family offices relying on Regulation 4.13(a)(6) are not subject to any notice filing requirement, and therefore will not be required to make this representation. The CFTC noted in the Adopting Release that family offices only serve “family clients,” and generally “pose little customer protection risk to the investing public.”

3) The Regulation 4.13 amendment as proposed would have included the statutory disqualifications under Section 8a(3) of the CEA, in addition to those under Section 8a(2). The CFTC stated in the Adopting Release that the Section 8a(2) statutory disqualifications are “the most serious offenses, which can trigger a statutory disqualification without a prior hearing."

4) Exemption From Registration for Certain Foreign Persons Acting as Commodity Pool Operators of Offshore Commodity Pools, 85 Fed. Reg. 35820 (June 12, 2020).

5) The proposal defines “control” as “the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting shares, by contract, or otherwise.”

6) While similar to the no-action relief provided in CFTC Staff Letter 15-46, the relief provided in that Staff Letter required a CPO to redeem the investment within two years of the initial seed capital investment.

7) AANA includes the notional value of uncleared swaps, uncleared security-based swaps, and physically settled foreign exchange forwards and swaps.

8) The U.S. Prudential Regulators are the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Farm Credit Administration and the Federal Housing Finance Agency.

9) Agencies Finalize Amendments to Swap Margin Rules, Board of Governors of the Federal Reserve System, Farm Credit Administration, Federal Deposit Insurance Corporation, Federal Housing Finance Agency and Office of the Comptroller of the Currency Joint Press Release (June 25, 2020). See also Margin and Capital Requirements for Covered Swap Entities, 85 Fed. Reg. 39754 (July 1, 2020). In the same interim final rule, the U.S. Prudential Regulators also set September 1, 2022 as the compliance date for uncleared swap counterparties with AANA of $8 billion.