United States: CFTC Proposes New Disclosure Requirements For Certain Commodity Pool Operators And Trading Advisors

The U.S. Commodity Futures Trading Commission ("CFTC") recently proposed an amendment to Rule 4.7 (the "Proposal") that would (i) introduce new minimum disclosure requirements for commodity pool operators ("CPOs") and commodity trading advisors ("CTAs") who operate pools and trading programs pursuant to CFTC Rule 4.7 ("Rule 4.7 CPOs and CTAs"), (ii) increase the monetary thresholds to qualify as a Qualified Eligible Person ("QEP"); and (iii) codify routinely issued exemptive relief allowing CPOs of funds-of-funds operated under Rule 4.7 to choose to distribute monthly account statements within 45 days of month-end.¹

Background

The CFTC adopted Rule 4.7 over 30 years ago to provide an exemption from certain disclosure, recordkeeping and filing requirements to CPOs and CTAs who operate privately offered pools and direct trading programs that are available exclusively to financially sophisticated investors and clients (i.e., QEPs). In the years since its adoption, the Rule 4.7 exemption has become the dominant registration status for CPOs and CTAs but remains essentially unchanged. At the same time, the scope of products subject to the CFTC's jurisdiction has expanded materially to include some of the world's most complex financial instruments. Considering these developments, the CFTC believes the proposed updates to Rule 4.7 are necessary to ensure that investors and clients in funds and trading programs operated pursuant to Rule 4.7 are sufficiently sophisticated and receive the information necessary to make informed decisions regarding investments in funds and trading programs with material exposure to commodity interest trading activity.

New Minimum Disclosure Requirements

Under the Proposal, Rule 4.7 CPOs and CTAs would be subject to a subset of the CFTC disclosure rules that currently apply to retail commodity pools and accounts. As a result, for the first-time, CPOs and CTAs would be generally required to disclose to prospective investors and clients in funds and accounts operated pursuant to Rule 4.7 ("Rule 4.7 Disclosures") information regarding:

1. principal risk factors,
2. the investment program,
3. the use of proceeds,
4. custodians,
5. fees and expenses,
6. conflicts of interest, and
7. past performance information.

While Rule 4.7 CPOs and CTAs often provide some form of disclosure to prospective investors and clients (e.g., via a private placement memorandum, Form ADV Part 2 Brochure, etc.) the proposed regulations are prescriptive, and the mandatory disclosures may not cleanly align with existing disclosure practices and the unconstrained investment mandates that are common in funds and accounts operated pursuant to Rule 4.7.

If the Proposal is adopted in its current form, any offering memorandum, account brochure or other disclosure statement delivered to prospective investors or clients in funds and accounts operated pursuant to Rule 4.7 would be required to include certain information including the following:

Fund Disclosures

Principal risk factors

• A discussion of the principal risk factors of participation in the offered fund, including, as applicable, risks relating to volatility, leverage, liquidity, counterparty creditworthiness, trading structures to be employed and investment activity (including retail forex and swap transactions) expected to be engaged in by the offered fund.

The investment program

• The types of assets which the fund will trade, including:
  • The approximate percentage of the fund's assets that will be used to trade commodity interests, securities and other types of investments, categorized by type of commodity or market sector, type of swap, type of security (debt, equity, preferred equity), whether traded or listed on a regulated exchange, maturity ranges and investment rating, as applicable;
  • The extent to which such investments are subject to state or federal regulation, regulation by a non-United States jurisdiction or rules of a self-regulatory organization;
  • The custodian or other entity (e.g., bank or broker-dealer) which will hold such assets; and if such assets will be held in or if the fund will invest in a non-United States jurisdiction, the jurisdiction in which such assets will be held or invested.
• A description of the trading and investment programs and policies that will be followed by the fund, including any material restrictions or limitations on trading and, if applicable, an explanation of the systems used to select CTAs, investee pools and types of investment activity to which pool assets will be committed.
• If the CPO has chosen a method for how the fund's futures commission merchants ("FCM") and/or retail foreign exchange dealers ("RFED") treat offsetting positions other than to close out all offsetting positions or to close out offsetting positions on other than a first-in, first-out basis, then then such method must be disclosed.
• A summary description of each CTA that is currently or will be allocated 10% or more of the fund's assets (each a "major CTA"), including its respective percentage allocations of pool assets, a description of the nature and operation of the trading programs such advisor will follow, including the types of investments traded pursuant to such program, and each advisor's historical experience trading such program including material information as to volatility, leverage and rates of return and the length of time during which the advisor has traded such program;
• A summary description of each fund in which 10% or more of the offered fund's net asset value is invested (each a "major investee pool"), including its respective percentage allocations of fund assets and a description of the nature and operation of such investee fund, including for each investee fund the types of investments traded, material information as to volatility, leverage and rates of return for such investee fund and the period of its operation; and
• How the fund will fulfill its margin requirements and the approximate percentage of the fund's assets that will be held in segregation under the Commodity Exchange Act, whether the fund will fulfill its margin requirements with other than cash deposits, the nature of such deposits; and if assets deposited by the fund as margin or as security deposit generate income, to whom that income will be paid.

Fees and expenses

• A complete description of each fee, commission and other expense which the CPO knows or should know has been incurred by the fund for its preceding fiscal year and is expected to be incurred by the fund in its current fiscal year, including fees or other expenses incurred in connection with the fund's participation in investee pools and funds. This description must include:
  • Management fees;
  • Brokerage fees and commissions, including interest income paid to FCMs, and any fees incurred to maintain an open position in retail forex transactions;
  • Fees and commissions paid in connection with trading advice provided to the fund;
  • Fees and expenses incurred within investments in investee funds and other collective investment vehicles, which fees and expenses must be disclosed separately for each investment tier;
  • Incentive fees;
  • Any allocation to the CPO, or any agreement or understanding which provides the CPO with the right to receive a distribution, where such allocation or distribution is greater than a pro rata share of the fund's profits based on the percentage of capital contributions made by the CPO;
  • Commissions or other benefits, including trailing commissions paid or that may be paid or accrue, directly or indirectly, to any person in connection with the solicitation of participations in the fund;
  • Professional and general administrative fees and expenses, including legal and accounting fees and office supplies expenses;
  • Organizational and offering expenses;
  • Clearance fees and fees paid to national exchanges and self-regulatory organizations;
  • For principal-protected fund, any direct or indirect costs to the fund associated with providing the protection feature;
  • Any costs or fees included in the spread between bid and asked prices for retail forex or, if known, swap transactions; and
  • Any other direct or indirect cost.
• Where a fee or other expense is determined by reference to a base amount (e.g., "net assets," "net gains," etc.) the CPO must explain how such base amount will be calculated.
• Where a fee or other expense is based on an increase in the value of the fund, the CPO must specify how the increase is calculated, the period during which the increase is calculated, the fee or other expense to be charged at the end of that period and the value of the fund at which payment of the fee or other expense commences.
• Where a fee or other expense of the fund has been paid or is to be paid by a person other than the fund, the CPO must disclose the nature and amount thereof and the person who paid or who is expected to pay it.
• An analysis, in tabular form, setting forth how the break-even point for the pool was calculated. The analysis must include all fees, commissions and other expenses of the pool.²

Conflicts of interest

• A full description of any actual or potential conflicts of interest regarding any aspect of the fund on the part of:
  • The CPO and any principal thereof;
  • The fund's trading manager, if any and any principal thereof;
  • Any major CTA and any principal thereof;
  • The commodity pool operator of any major investee pool and any principal thereof;
  • Any other person providing services to the fund, soliciting participants for the fund, acting as a counterparty to the fund's retail forex or swap transactions, or acting as a swap dealer with respect to the fund.
• Any other material conflict involving the fund including any arrangement whereby a person may benefit, directly or indirectly, from the maintenance of the fund's account with the FCM and/or RFED and/or from the maintenance of the fund's swap positions with a swap dealer, or from the introduction of the fund's account to an FCM and/or RFED and/or swap dealer by an introducing broker (such as payment for order flow or soft dollar arrangements) or from an investment of fund assets in investee funds or other investments.

Past Performance

• Fund performance must be presented in capsule format and include certain information, net of any fees, expenses or allocation to the CPO, such as:
  • The aggregate gross capital subscriptions to the fund;
  • The fund's current net asset value;
  • The largest monthly draw-down during the most recent five calendar years and year-to-date, expressed as a percentage of the fund's net asset value and the month and year of the draw-down;
  • The worst peak-to-valley draw-down during the most recent five calendar years and year-to-date, expressed as a percentage of the fund's net asset value, as well as the period the draw-down occurred. The period begins with the peak month and year and ends with the valley month and year; and
  • The annual and year-to-date rate of return for the fund's most recent five calendar years and year-to-date, computed on a compounded monthly basis.
• Additional disclosures required for funds with less than a three-year operating history,³ include:
  • The performance of any accounts (including pools) directed by each major CTA and any major investee pool, presented in accordance with CFTC Rules; and
  • A summary description of the performance history of all other non-major CTAs and investee pools.

Disclosures generally

• The offering memorandum must include all other disclosures necessary to make the information contained therein, in the context in which it is furnished, not misleading.

Account Disclosures:

Principals and brokers

• The names of each principal of the CTA and each FCM, IB and/or RFED required to be used by the client or if the choice of such broker is at the client's discretion, a statement to that effect.

Principal risk factors

• A discussion of the principal risk factors of the trading program, including, as applicable to the trading program, risks due to volatility, leverage, liquidity, and counterparty creditworthiness, and the types of transactions and investment activity expected to be engaged in pursuant to such program (including retail forex and swap transactions, if any).

Trading program

• A description of the trading program, which must include the types of commodity interests and other investments the CTA intends to trade, with a description of any restrictions (e.g., minimum account size) or limitations on such trading established by the trading advisor or otherwise.
• Where the CTA has chosen a method for treating offsetting positions held at an FCM or RFED other than to close out all offsetting positions or to close out offsetting positions on other than a first-in, first-out basis, then such method must be disclosed.

Fees

• A complete description of each fee which the CTA will charge the client.
  • Where any fee is determined by reference to a base amount (e.g., "net assets," "gross profits," "net profits," etc.) or based on the difference between bid and asked prices on retail forex or swaps, an explanation of how such base amount or fee will be calculated must be provided.
  • Where any fee is based on an increase in the value of the client's account, how that increase is calculated, the period of time during which the increase is calculated, the fee to be charged at the end of that period and the value of the account at which payment of the fee commences.

Conflicts of interest

• A full description of any actual or potential conflicts of interest regarding any aspect of the trading program on the part of:
  • The CTA;
  • Any FCM, IB or RFED with which the client will be required to maintain an account or otherwise use;
  • Any principal of the foregoing; and
  • Any other material conflict involving any aspect of the offered trading program, including any arrangement whereby the advisor or any principal thereof may benefit, directly or indirectly, from the client's use of an FCM, RFED, IB or swap dealer (such as payment for order flow or soft dollar arrangements).

Past Performance

• Except for proprietary trading results, the CTA must disclose in capsule format performance information for all accounts directed by the CTA and each of its trading principals⁴ for the past five years and year to date, including:
  • The name of the CTA or other person trading the account and the name of the trading program.
  • The date on which the CTA or other person trading the account began trading client accounts and the date when client funds began being traded pursuant to the trading program.
  • As of the date of the disclosure statement:
    • The number of accounts directed by the CTA or other person trading the account pursuant to the trading program;
    • The total assets under the management of the CTA or other person trading the account; and
    • The total assets traded pursuant to the specified trading program.
  • The largest monthly draw-down experienced by the trading program during the most recent five calendar years and year-to-date expressed as a percentage, as well as the month and year of the draw-down;
  • The worst peak-to-valley draw-down experienced by the specified trading program during the most recent five calendar years and year-to-date, as well as the period the draw-down occurred;
• Additional performance information for the offered trading program must be provided, including:
  • Monthly rates of return for the five most recent calendar years and year-to-date, either in a numerical table or in a bar graph, and annual and year-to-date rate of return for the same period.
  • The number of accounts traded pursuant to the offered trading program that were opened and closed during the period with positive net lifetime performance as of the date the accounts were closed.
  • and the range of returns experienced by these accounts.
  • The number of accounts traded pursuant to the offered trading program that were opened and closed during the period with negative net lifetime performance as of the date the accounts were closed.
  • and the range of returns experienced by these accounts.

Disclosures generally

• The account brochure must include all other disclosures necessary to make the information contained therein, in the context in which it is furnished, not misleading.

Disclosure updates

• Rule 4.7 Disclosures:
  • Must be current as of the date of the disclosure statement except performance information, which may be current as of a date not more than three months prior thereto.
  • At all times must be materially accurate and complete.
    • Defects must be corrected and corrections must be distributed to current and previously solicited prospective investors and clients.
    • The disclosure statement may not be used until such correction is made.
• Disclosure statements may not be used if dated more than twelve months prior to the date of use.

Increased Regulatory Scrutiny

The Proposal represents a significant policy shift by the CFTC with respect to Rule 4.7 Disclosures. Currently, Rule 4.7 CPOs and CTAs are largely exempt from CFTC disclosure mandates. Where CPOs and CTAs voluntarily provide Rule 4.7 Disclosures, existing CFTC Rules require such information to "include all disclosures necessary to make the information contained therein, in the context in which it is furnished, not misleading."⁵ This standard is fundamentally different and much lower than the proposed requirement that Rule 4.7 Disclosures be generally mandatory and regularly updated so that they remain materially accurate and complete. The result is that, under the Proposal, Rule 4.7 Disclosures would be subject to materially greater regulatory oversight. The CFTC and National Futures Association would be able to review Rule 4.7 Disclosures for accuracy through the examination process by comparing the disclosures against trading data and other information provided through periodic filings such as Form PQR and Form PR. Such disclosure reviews would open an additional avenue for potential civil enforcement actions.⁶

Other Components of the Proposed Rule

Increase to QEP "Portfolio Requirement" Monetary Thresholds

All investors and clients in funds and accounts operated pursuant to Rule 4.7 must be QEPs. To qualify as QEPs, certain investors, including some natural persons, must satisfy a monetary threshold know as the "Portfolio Requirement." Under the Proposal:

• The current Portfolio Requirement would double under the "Securities Portfolio Test"⁷ to $4,000,000 and under the "Initial Margin and Premium Test"⁸ to $400,000.
• Qualified Purchasers, as defined in the Investment Company Act of 1940, would, by definition, continue to qualify as QEPs.
• An investor or client in a 4.7 pool or account who no longer qualifies as a QEP due to the proposed rule amendment may remain in the 4.7 fund or account but would not be permitted to subscribe to new interests in the 4.7 fund.

Codified Common Relief for Fund of Funds

• The Proposal would codify relief for CPOs operating funds-of-funds who choose to distribute monthly account statements within 45 days of month-end (such statements may otherwise be distributed within 30-days of quarter-end).
• Currently, CPOs who desire to benefit from this extended timeline must be granted no-action relief by CFTC staff.

Comments

The CFTC has asked for comments generally on the Proposal and posed specific questions designed to help it better assess the costs and benefits of the Proposal including:⁹

1. To what extent is the information necessary to provide past performance and fees already gathered in order to provide account information under Regulations 4.7 and 4.22? What additional steps would be required to process and disseminate that information in Rule 4.7 Disclosures, as required under the Proposal?
2. What are the costs of gathering and disseminating the other types of information required to be included in Rule 4.7 Disclosures?
3. How will the fees and expenses charged by CPOs and CTAs for pools and trading programs operated under Rule 4.7 be affected by the proposed disclosure requirements?
4. To what extent would CPOs' and CTAs' trading strategies be revealed in Rule 4.7 Disclosures? How would such proposed disclosure requirements impact the development of such trading strategies and/or directly affect the behaviors of CPOs and CTAs utilizing Rule 4.7?

Commissioner Summer Mersinger in her dissent to the Proposal invited comments on additional questions related to the proposed disclosure mandate including:¹⁰

• Do QEPs agree that the Commission should impose universal disclosure requirements on Rule 4.7 CPOs and CTAs? Why or why not?
• Is the Commission correct in its preliminary belief that universal disclosure requirements to QEPs are necessary to address the unequal bargaining power of QEPs? Would they be necessary if the Commission's proposed increases to the Portfolio Requirement monetary thresholds in the QEP definition are adopted?
• Is the Commission correct in its preliminary belief that universal disclosure requirements to QEPs are necessary in light of significant expansion and growth in the complexity and diversity of commodity interest products offered to QEPs via 4.7 pools and trading programs, and in light of the rapid pace of innovation in the commodity interest markets?
• Is the Commission correct in its preliminary belief that the development of markets for swaps and digital assets necessitates universal disclosure requirements to QEPs?
• Are there alternative, more tailored, means by which the Commission could achieve its policy objectives than the universal disclosure requirements to QEPs that it is proposing? If so, please describe.
• Should the Commission impose universal disclosure requirements to QEPs that are capable of protecting their own interests in order to incorporate the review of such disclosures into its existing examination processes if such review comes at the expense of other Commission responsibilities? Why or why not?
• To what extent will the proposed universal disclosure requirements to QEPs impact the benefits that Rule 4.7 CPOs and CTAs derive from relying on the exemptions in Rule 4.7? Is it likely that Rule 4.7 CPOs and CTAs will decide to no longer rely on the remaining exemptions afforded by Rule 4.7 if the proposed universal disclosure requirements to QEPs are adopted?
• If a Rule 4.7 CPO or CTA is registered as an investment adviser with the SEC and not subject to an exemption regarding disclosures required by the SEC, should the CFTC accept compliance with disclosures required by the SEC as sufficient to satisfy the proposed universal disclosure requirements to QEPs under Rule 4.7, too?
• Is the Commission's PRA estimate of 1.5 annual burden hours per response for the disclosures proposed to be required of Rule 4.7 CPOs and CTAs appropriate? If not, what would be an appropriate estimate?

The 60-day comment period closes on December 10, 2023.

Footnotes

1. 88 Fed. Reg. 70852 (Oct. 12, 2023).

2. Under the Proposal, Rule 4.7 CPOs would not be required to provide the break-even point per unit of initial investment under Rule 4.24(d)(5) but would be required to provide the tabular break-even point analysis under Rule 4.24(i)(6). It is unclear whether this apparent conflict was intentional.

3. Three year operating history in this context means that the fund has traded commodity interests for three or more years and during that time, seventy-five percent or more of the contributions to the pool were made by persons unaffiliated with the CPO, the trading manager (if any), the fund's CTAs, or the principals of any of the foregoing.

4. Trading principals are any principals of the CTA who participate in making trading decisions for the CTA's clients or who supervise or select persons so engaged.

5. 17 CFR 4.7(b)(2); 17 CFR 4.7(c)(1)

6. 88 Fed. Reg. at 70860

7. The Securities Portfolio Test measures ownership of "securities . . . of issuers not affiliated with such person and other investments..." 17 CFTC 4.7

8. The Initial Margin and Premium Test measures the amount a person has "on deposit with a futures commission merchant . . . at any time during the six months preceding" the date of participation in a Rule 4.7 pool or account in "exchange-specified initial margin and option premiums . . . for commodity interest transactions." 17 CFTC 4.7

9. See 88 Fed. Reg. at 70872

10. See 88 Fed. Reg. at 70881

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