[author: Steve Quinlivan]

Perhaps one of the most important questions since the Dodd-Frank Act is “What is a commodity pool”?  Close behind is “Who is a commodity pool operator”?  The CFTC has begun to shed light on these questions by issuance of interpretive guidance for equity REITS and securitization vehicles.

Equity REITS

The REIT guidance begins by reviewing the history from the CFTC’s point of view (foot notes omitted):

“In 1981, the Commission proposed and adopted the definition of “pool” in Commission Regulation 4.10(d), which provided that “pool” means “any investment trust, syndicate or similar form of enterprise operated for the purpose of trading commodity interests.” At that time there was no statutory definition of a commodity pool. The statutory definition of commodity pool, as it currently appears in Section 1a(10) of the CEA, is substantively identical to the Commission’s longstanding regulatory definition of the term “pool.”

From the time of its adoption in 1981, the Commission has declined to constrain the phrase “operated for the purpose of trading” to the narrowest of possible interpretations. The reasons that the Commission articulated for rejecting a narrow understanding of the phrase were grounded in its dual concerns for customer and market protection. The Commission noted in the Preamble to the 1981 rule that commenters were concerned that the definition was overly broad.  One commenter suggested a brightline percentage test as a function of commodity interests to other portfolio holdings to determine whether a collective investment scheme should be considered a pool. The Commission declined to set a specific percentage as a threshold over which an entity would be considered a commodity pool due to concerns that an entity which would not exceed the set trading level could still be marketed as a commodity pool to participants, who should be afforded the protections under Part 4 of the Commission’s regulations.”

Several other commenters suggested that the definition should be narrowed to only those funds whose “principal purpose” was the trading of commodity interests. The Commission rejected that suggestion because it could “inappropriately exclude from the scope of the Part 4 rules certain persons who are, in fact, operating commodity pools.” Thus, the Commission recognized that there may be entities whose primary business focus may be outside the commodity interest sphere, yet may still have a significant exposure to those markets, which may implicate the Commission’s concerns regarding both customer and market protection. The rejection of the more narrow “principal purpose” language further indicated the Commission’s determination to expand the constrained meaning of the phrase “operated for the purpose of.” There is no evidence in the legislative record to indicate that when Congress adopted a statutory definition of “commodity pool,” that is substantively identical to the Commission’s longstanding regulatory definition of “pool,” it intended for the Commission to modify its understanding of the scope of phrase “operated for the purpose of.”

The Commission affirmed and refined this interpretation in the preamble to the final rule entitled Commodity Pool Operators and Commodity Trading Advisors: Compliance Obligations. Explaining its amendments to Commission Regulations 4.5 and 4.13(a)(3) to include swaps in the trading thresholds, the Commission stated, “any swaps activities undertaken by a CPO would result in that entity being required to register because there would be no de minimis exclusion for such activity. As a result, one swap contract would be enough to trigger the registration requirement.” This statement is the Commission’s most recent guidance with respect to the relationship between an entity’s swaps activity and the requirement that its operator register as a CPO.”

The CFTC’s Division of Swap Dealer and Intermediary Oversight, or the Division, believes that REITs that primarily derive their income from the ownership and management of real estate and that use derivatives for the limited purpose of “mitigat[ing] their exposure to changes in interest rates or fluctuations in currency” are outside the definition of “commodity pool” under Section 1a(10) of the CEA and Commission Regulation 4.10(d).  However an equity REIT must satisfy the following criteria:

• The REIT primarily derives its income from the ownership and management of real estate and uses derivatives for the limited purpose of “mitigat[ing] their exposure to changes in interest rates or fluctuations in currency”;
• The REIT is operated so as to comply with all of the requirements of a REIT election under the Internal Revenue Code, including 26 U.S.C. §856(c)(2) (the 75 percent test) and 26 U.S.C. §856(c)(3) (the 95 percent test); and
• The REIT has identified itself as an equity REIT in Item G of its last U.S. income tax return on Form 1120-REIT and continues to qualify as such, or, if the REIT has not yet filed its first tax filing with the Internal Revenue Service, the REIT has stated its intention to do so to its participants and effectuates its stated intention.

Securitizations

Here the proponent requesting guidance argues  that securitization vehicles do not satisfy the definition of commodity pool, and more specifically, that securitization vehicles do not meet the criteria articulated by the Ninth Circuit in Lopez v. Dean Witter Reynolds Inc.  The proponent stated that most securitization vehicles do not have multiple equity participants, do not have pro rata allocations of accrued profits or losses because the issued interests are in the form of debt or debt-like interests with a stated interest rate or yield and principal balance and a specific maturity date, and do not have a purpose of trading in swaps or other commodity interests. The proponent also asserted that securitization vehicles are “capital markets financings of sales finance or other financial asset inventory” as opposed to an investment trust.

The guidance notes the Division believes that, consistent with the Commission’s longstanding statements regarding the analysis of whether a fund is a pool, although the Lopez factors are useful, they are not dispositive and the failure of a fund to satisfy one or more of the factors does not mean that the fund is not a pool. The Division believes that it is required to evaluate the facts and circumstances presented in their entirety and determine whether a pooled investment vehicle possessing such characteristics should properly be considered to be a commodity pool. In attempting to make such an evaluation based on the characteristics presented, the Division tends to agree that certain entities that meet certain of the criteria identified are likely not commodity pools, such as securitization vehicles that do not have multiple equity participants, do not make allocations of accrued profits or losses, and only issue interests in the form of debt or debt-like interests with a stated interest rate or yield and principal balance and a specific maturity date. Other sorts of financings or investments, however, based on the descriptions provided by the proponent, do not preclude the issuer or, in the case of a covered bond, the related covered pool from being a commodity pool. Thus, the Division believes the request for relief for entities operating to some extent under any covered bond statute, entities involved in collateralized debt obligations, entities involved in collateralized loan obligations, any insurance-related issuances, and any other synthetic securitizations is overly broad and does not provide any assurance that the related entities or a portion of their assets, operations, or activities would not properly be considered a commodity pool (emphasis added).

Based on an evaluation of the facts and circumstances presented regarding securitization vehicles and their issuance of asset-backed securities, the Division has determined that certain securitization vehicles should not be included within the definition of “commodity pool” and its operator should not be included within the definition of “commodity pool operator.” The Division has determined that the criteria for exclusion include the following:

• The issuer of the asset-backed securities is operated consistent with the conditions set forth in Regulation AB, or Rule 3a-7, whether or not the issuer’s security offerings are in fact regulated pursuant to either regulation, such that the issuer, pool assets, and issued securities satisfy the requirements of either regulation;
• The entity’s activities are limited to passively owning or holding a pool of receivables or other financial assets, which may be either fixed or revolving, that by their terms convert to cash within a finite time period plus any rights or other assets designed to assure the servicing or timely distributions of proceeds to security holders;
• The entity’s use of derivatives is limited to the uses of derivatives permitted under the terms of Regulation AB, which include credit enhancement and the use of derivatives such as interest rate and currency swap agreements to alter the payment characteristics of the cash flows from the issuing entity;
• The issuer makes payments to securities holders only from cash flow generated by its pool assets and other permitted rights and assets, and not from or otherwise based upon changes in the value of the entity’s assets; and,
• The issuer is not permitted to acquire additional assets or dispose of assets for the primary purpose of realizing gain or minimizing loss due to changes in market value of the vehicle’s assets.

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