National Futures Association Advises Commodity Pool Operators on Prohibited Loans

by Goodwin

The National Futures Association (the “NFA”) issued a notice advising its members that amendments to its Compliance Rule 2-45 and a related Interpretive Notice became effective on September 13, 2013.  Compliance Rule 2-45 prohibits a commodity pool operator (“CPO”) from making a direct or indirect loan or advance of pool assets to the CPO or any other affiliated person or entity.  The NFA has determined that Compliance Rule 2-45 was not intended to prohibit certain transactions that are entered into in the ordinary course of business by funds managed by certain CPOs that were previously exempt from registration prior to December 31, 2012.  Accordingly, the NFA amended Compliance Rule 2-45 to provide that certain transactions specified in the Interpretive Notice are permitted despite having characteristics similar to a loan.

Other Applicable Compliance Rules.  The Interpretive Notice notes that under NFA’s existing compliance rules, any such arrangements must be consistent with a pool’s current disclosure document or offering materials, and both the loan(s) or advance(s) and the related conflicts of interest must be fully disclosed to pool participants. In addition, NFA’s rules require a loan or advance to be secured by marketable, liquid assets (e.g., a CPO participant’s pro rata interest in the pool’s liquid assets).

Types of Pools.  The Interpretive Notice specifies certain types of pools that a CPO may cause to engage in enumerated transactions (specified below) without violating Compliance Rule 2-45.   The Interpretive Notice applies with respect to a pool that is:

  • a registered investment company (“RIC”),
  • a business development company (“BDC”),
  • exempt pursuant to CFTC Regulations 4.7 or 4.13(a)(3),
  • excluded from registration pursuant to Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (the “1940 Act”), or
  • securities registered under the Securities Act of 1933. 

Types of Transactions.  The enumerated transactions are:

  • certain securities borrowings/securities loans pertaining to short sales, provided that no later than the close of business on the day of the securities loan, the pool lending the security has received from the pool borrowing the security collateral with a market value at least equal to the market value of the borrowed security;
  • securities loans in which a pool lends securities to an affiliate as part of a prime brokerage service, and receives cash based on the market value of the securities lent, provided that: (i) the transaction is cleared by an affiliated prime broker that is registered with the SEC as a broker-dealer, and is a member of FINRA, the Depository Trust Company and the National Securities Clearing Corporation; and (ii) the transaction is documented under an Master Securities Loan Agreement;
  • a direct or indirect debt or equity investment by a pool in a subsidiary or other affiliated entity for tax, legal, regulatory, or other reasons coupled with a guarantee  or other credit support (e.g., a pledge of collateral) in accordance with the pool’s relative investment, provided that a pool is not liable for an amount that is materially above its proportionate share (based on the pool’s relative investment in the guaranteed entity from time to time);
  • repurchase agreements and reverse repurchase agreements among affiliated pools in which there is a sale of securities combined with a contemporaneous agreement for the seller to buy back the securities at a later date at a higher price (which the Interpretive Notice states do not violate Compliance Rule 2-45 because the buyer’s possession of the securities effectively collateralizes its exposure in respect to the seller’s obligation to repurchase the securities);
  • tax-related loans, advances, or distributions by a pool to its CPO or a related party, provided that (a) such distributions are made in strict accordance with the provisions of the pool’s organizational documents that expressly permit the distribution and (b) certain other conditions are met; and
  • transactions by a CPO operating a pool that is a RIC or BDC that are permitted by (1) the 1940 Act and its exemptive rules, (2) an exemptive order issued by the SEC, or (3) a no‑action letter issued by the SEC staff under Section 17 or Section 57 of the 1940 Act.

Transactions Outside the Exceptions – Notice Obligation.  The Interpretive Notice provides that a CPO whose pool is involved in a direct or indirect loan or advance of pool assets that falls outside the exceptions described in the Interpretive Notice must notify the NFA of the arrangement by October 13, 2013 .  Persons that become NFA member CPOs in the future must notify the NFA of such arrangements within thirty days of becoming an NFA member CPO.

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this informational piece (including any attachments) is not intended or written to be used, and may not be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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.

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