CFTC’s Final 'Harmonization' Rules: Shifting Sands in the ETF Competitive Landscape

by Reed Smith
Contact

Background

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.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Reed Smith | Attorney Advertising

Written by:

Reed Smith
Contact
more
less

Reed Smith on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.
Feedback? Tell us what you think of the new jdsupra.com!