In 2012, the Commodity Futures Trading Commission (CFTC), in response to Dodd-Frank, adopted new regulations to require mutual funds and other registered investment companies that exceed certain position levels in commodity futures and options to register with the CFTC, in addition to registration with the Securities and Exchange Commission (SEC). The Investment Company Institute (ICI) and U.S. Chamber of Commerce (the Chamber) promptly sued to enjoin the new regulations, contending that the CFTC had not met its procedural burdens under the Administrative Procedure Act (APA). The ICI and Chamber also contended that the new regulations were substantively flawed because they would impose duplicative and unnecessary burdens and costs on the funds industry and, ultimately, on fund investors.
The U.S. Court of Appeals for the D.C. Circuit this week, in Investment Company Institute v. CFTC, rejected the plaintiffs' arguments and affirmed a lower court's decision granting summary judgment in favor of the CFTC. As a result, mutual funds and their advisers will now be subject to dual registration with the SEC and CFTC if their commodities positions exceed the designated threshold.
BACKGROUND: THE CFTC'S NEW REGULATIONS
The Commodity Exchange Act (CEA) requires that Commodity Pool Operators (CPOs) register with the CFTC and adhere to regulatory requirements regarding disclosures, recordkeeping and reporting. The CEA defines CPOs as including any entity "engaged in a business that is of the nature of a commodity pool, investment trust, syndicate, or similar form of enterprise" that receives funds or securities "for the purpose of trading in commodity interests." The CEA, however, provides that the CFTC may exclude an entity from the term CPO if the CFTC determines that such exclusion will effectuate the CEA's purposes. (CEA § 1a(11)(A), (B).)
Pursuant to this authority, CFTC Regulation § 4.5 excludes various "otherwise regulated" entities, including investment companies registered under the Investment Company Act of 1940 (Registered Investment Companies, or RICs) that meet various conditions. Prior to 2003, one of these conditions was that the RIC not exceed certain limits on commodities positions established not "solely for bona fide hedging purposes" (as defined in other CFTC regulations), specifically that it "not enter into commodity futures and commodity options contracts for which the aggregate initial margin and premiums exceed 5 percent of the fair market value of the [RIC]'s assets."
In 2000, Congress passed the Commodity Futures Modernization Act of 2000, which barred the CFTC from regulating most swaps. The CFTC thereafter amended Regulation § 4.5 to eliminate the five percent threshold on commodities positions. As a consequence, since 2003, most RICs have been able to hold substantial commodities positions, without the need for CFTC registration.
The financial crisis, however, led Congress to reverse course. In 2010, Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), with the intent of increasing regulation of the securities and commodities markets. In particular, Dodd-Frank made more types of commodities transactions subject to CFTC oversight and gave the CFTC regulatory authority over swaps.
In 2012, the CFTC, citing its new "more robust mandate" under Dodd-Frank "to manage systemic risk and to ensure safe trading practices by entities involved in the derivatives markets," promulgated a revised Regulation § 4.5 and a new Regulation § 4.27, following a notice-and-comment period. Together, these regulations would largely return to the pre-2003 regulatory framework, re-imposing the five percent threshold on commodities positions (while also providing that a RIC could alternatively claim exclusion if the aggregate net notional value of its commodities positions was no more than 100 percent of "the liquidation value of the pool's portfolio"). In adopting the new regulations, the CFTC also sought comment on possible changes to certain disclosure requirements to harmonize them with corresponding SEC requirements.
As a result of the new CFTC regulations, most RICs that hold commodities positions in excess of the five percent threshold would be required to register with the CFTC, as was the case before 2003. Notably, however, in line with Dodd-Frank's grant to the CFTC of authority over swaps, the new regulations for the first time provide that swaps are to be included in determining whether a RIC exceeds the five percent threshold on commodities positions. As a result, a sizable number of RICs will now be unable to rely on the Regulation § 4.5 exclusion and will be required to register with the CFTC.
THE COURTS REJECT THE PLAINTIFFS' CHALLENGE
Prior to the CFTC's adoption of the new regulations, the ICI and Chamber submitted comment letters in opposition. Among other concerns, the ICI questioned "the need for a second level of regulation on registered investment companies, which are already subject to comprehensive regulation" under the Investment Company Act and other federal securities laws. The Chamber cited "the adverse effects on the mutual fund industry [and] the financial markets more generally" as a result of restrictions imposed on the funds' "legitimate use of futures contracts."
After adoption of the regulations, the ICI and Chamber jointly filed suit in the U.S. District Court for the District of Columbia to enjoin them. The APA directs courts to set aside actions by agencies such as the CFTC that are found to be "arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with the law." The plaintiffs claimed that the CFTC had acted in an arbitrary and capricious manner in violation of the APA, and had failed to comply with the analysis required under the CEA. On December 12, 2012, District Court Judge Beryl Howell rejected these claims, and granted summary judgment to the CFTC.
On appeal, the ICI and Chamber contended that the CFTC had violated the APA by (i) failing to address the CFTC's own prior rationale in 2003 for broadening the exclusions from the definition of CPO; (ii) inadequately evaluating the regulations' costs and benefits; (iii) including swaps in the trading threshold, restricting the definition of bona fide hedging and failing to justify the five percent threshold; and (iv) failing to provide an adequate opportunity for notice and comment.
In a decision issued June 25, 2013, the D.C. Circuit addressed and rejected each of the plaintiffs' contentions. Specifically: (i) the court found that the CFTC had articulated sufficient reason to reverse its 2003 action and again provide that positions exceeding the five percent threshold would trigger the CFTC registration requirement; (ii) the CFTC had engaged in an adequate cost-benefit analysis, including its determination that CFTC regulation of non-excluded RICs was necessary in addition to SEC regulation; (iii) the CFTC had offered reasoned explanations for the various particulars in the regulations that the plaintiffs had challenged; and (iv) the CFTC had provided adequate opportunity for comment on the proposed regulations. Overall, the court rejected many of the plaintiffs' contentions as "nothing more than... policy disagreement[s]" with the CFTC, which are an insufficient basis for setting aside agency action.
Plaintiffs have had a great run of success in recent years in persuading D.C. courts to set aside SEC and CFTC rules on grounds similar to those the ICI and Chamber urged here. These cases include last September's decision by the D.C. District Court, International Swaps and Derivatives Association v. CFTC, which vacated the CFTC's "position limits rule," based on the court's finding that the CFTC had misinterpreted certain Dodd-Frank amendments to the CEA.
This week's victory by the CFTC is a major boost for the government regulators, not only for their ability to defend their own rulemaking, but more importantly for the CFTC's regulatory and enforcement powers over the mutual fund industry. Under the new CFTC regulations found to be lawful, many mutual funds and their advisers will now need to register not only with the SEC, but also with the CFTC. The extent of the additional costs and other burdens to be imposed by this scheme of dual registration remains to be seen. In the meantime, the industry awaits the CFTC's issuance of additional rules intended to minimize such burdens by harmonizing CFTC and SEC requirements.