The Commodity Futures Trading Commission (CFTC) caused quite a stir in 2012 when it changed its rules to require investment advisers to mutual funds that invest to any significant degree in derivatives, to register as "Commodity Pool Operators" (CPOs). The CFTC’s actions drew the ire of the mutual fund industry to such an extent that industry groups challenged the rules in court.
Notwithstanding widespread industry opposition, the CFTC stuck to its guns, perceiving a need to regulate mutual funds employing increasingly complex derivatives strategies. At the same time, the CFTC recognized that the application of its rules could create overlapping and even inconsistent regulation since mutual funds are extensively regulated by the Securities and Exchange Commission (SEC) under the federal securities laws (primarily, the Investment Company Act of 1940 (1940 Act)).
Accordingly, in February 2012, when it began requiring certain mutual fund advisers to register as CPOs, the CFTC did three things: First, it extended to all mutual funds, exemptions from certain procedurally oriented rules that it had previously granted to "exchange traded funds" (ETFs). Second, it undertook a study of its more substantive rules, such as those that stipulate what types of disclosure investors must receive, to determine which rules funds ultimately should be required to comply with. Third, it deferred the implementation of a rule that required a mutual fund’s registered CPO to file a Form CPO-PQR.
How Will the New Harmonization Rules Impact Mutual Funds and ETFs?
On August 12, 2013, the CFTC adopted final "harmonization" rules. For mutual funds and ETFs regulated under the 1940 Act, the CFTC chose to deem a fund’s adviser to be in compliance with the CFTC’s recordkeeping, reporting, disclosure, and performance requirements, if the fund is in compliance with applicable SEC requirements. The only exception to this general rule is that an adviser must include the performance of related investment funds and accounts with similar investment strategies, if the fund has less than three years of performance history. In order to claim the relief, the fund must file a notice and bring its disclosure into compliance with certain technical requirements during the course of its regular annual update cycle. In the release adopting the final harmonization rules, the CFTC also indicated that, 60 days after the effective date of the rulemaking, a mutual fund’s registered CPO will be required to comply with the CFTC rule that requires that adviser to file a Form CPO-PQR.
Importantly, however, an increasing number of ETFs are not regulated under the 1940 Act. These ETFs track commodities and currencies and have become a popular tool for diversifying investors’ portfolios and, in some cases, providing institutional investors with tools for implementing active trading strategies. Commodities ETFs have been subject to dual SEC and CFTC regulation for years. More precisely, the ETFs’ shares are registered under the Securities Act of 1933 (1933 Act) similarly to conventional corporate issuers, while the funds, categorized as "commodity pools" under the federal commodities laws, subject their sponsors to regulation as CPOs.
How will the CFTC’s harmonization rules impact commodities ETFs? The primary impact will be to remove a regulatory requirement that has proved particularly onerous – the requirement to update their prospectuses every nine months, rather than annually as required of mutual funds and 1940 Act ETFs. However, while the elimination of the nine-month updating requirement represents welcome relief, commodities ETFs and their accountants and lawyers will continue to have to grapple with multiple layers of disclosure rules that present challenges for even seasoned fund complexes.
Commodities ETF prospectuses are typically more than 100 pages long, while commensurate mutual fund prospectuses may be 20-30 pages long. There are two primary reasons for this disparity: First, Form S-1, the general registration form under the 1933 Act, has more extensive requirements than Form N-1A, the corresponding registration form under the 1940 Act. Commodities fund prospectuses therefore contain extensive risk and analytical market disclosure, not to mention an ongoing requirement to prepare periodic reports as required by the Securities Exchange Act of 1934. Second, a separate disclosure regime is imposed on commodities ETFs as "commodity pools" by CFTC and National Futures Association (NFA) rules. Chief among these requirements is to present in prospectuses the historical performance for every other commodity pool managed by an ETF’s manager, the requirement for a "breakeven table," and certain standard risk disclosure.
The harmonization rules represent a significant victory for mutual funds and 1940 Act ETFs, because the CFTC, with one exception, deferred subjecting these funds to additional disclosure requirements. How did commodity ETFs fare? They scored well in the sense that eliminating the nine-month prospectus updating requirement will ease compliance costs. Nonetheless, important regulatory disparities remain for commodities ETFs, and developing and implementing the necessary compliance procedures to launch a new commodities ETF will remain a resource-intensive proposition.
Proponents of commodities ETFs have for years called for applicable SEC and CFTC rules to be harmonized, but the CFTC’s recent harmonization rules fall short of this goal. The new rules barely made a dent in the overlapping regulatory regime applicable to commodities ETFs, while mutual funds and 1940 Act ETFs will benefit from a disclosure and compliance system tailored for the attributes of these types of investments.
We note in closing that the harmonization rules will require mutual funds and ETFs generally to adopt new compliance procedures.