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Hedge Fund Alert

August 1998

What If You Use Futures In Your Trading Strategy?

By: George J. Mazin, Esq.

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ne of the first questions new managers should consider is whether futures will be used as a part of the manager’s trading strategy. If the answer is yes, the hedge fund manager will likely become subject to the comprehensive regulatory regime administered by the Commodity Futures Trading Commission (“CFTC”) and the National Futures Association (“NFA”). This regime imposes a host of regulatory responsibilities on the manager, including testing, ethics training, disclosure

• bligations, and accounting and reporting
• requirements. The manager also becomes subject

to the anti-fraud provisions of the Commodity Exchange Act. A brief presentation, such as this Alert, cannot present all material aspects of the commodities laws. It does, however, outline some

• f the more important requirements of which a

manager must be aware.

Who Must Register?

A person may not operate a commodity pool unless registered as a commodity pool

• perator. The Commodity Exchange Act (the

“Act”) broadly defines a commodity pool operator as “a person engaged in a business that is in the nature of an investment trust, syndicate or similar form of enterprise, and who, in connection therewith, solicits, accepts or receives from others funds . . .for the purpose of trading in any

• commodity. .” The starting point in the analysis
• f whether a manager is a commodity pool
• perator is to determine whether the fund or
• ther pooled investment vehicle managed by that

manager is a “commodity pool.” Although there are some notable exceptions described below, in general, a fund which engages in the trading of commodity interests (however incidental the trading may be) is a commodity pool and the manager of that fund is a commodity pool operator, subject to the registration requirements of the Act. For a domestic partnership, the general partner of the partnership is the commodity pool operator and is required to register in this capacity. In the case of an offshore fund, if the investment manager is in the United States and trades commodity interests

• n U.S. commodity exchanges, the investment

manager will generally be required to register as a commodity trading advisor. In addition to the registration requirements applicable to the general partner, the members or partners of the general partner will be required to register as principals of the commodity pool

• perator or commodity trading advisor. Other

employees involved in making trading decisions with respect to futures or soliciting investors will generally be required to register as associated persons. As part of the process, all persons applying for registration will be required to pass the Series 3

• exam. The CFTC has delegated to the NFA

(which is a self-regulatory organization) authority to regulate the managed futures industry. The NFA has been willing to waive the examination requirement under a variety of circumstances. In a published interpretive notice, the NFA has stated that in the case of a fund that engages principally in securities transactions, which commits only a small percentage of its assets as initial margin for futures

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and options on futures and uses futures transactions and options solely for hedging or risk management purposes, the NFA is authorized to waive the exam requirement. In addition, for funds which do not limit their use of futures solely for hedging or risk management purposes, a waiver

• f the exam may be available if there is at least one

registered principal who has taken and passed the examination and the person requesting the waiver is not involved in marketing interests in the fund

• r making investment decisions concerning the

use of futures.

Is There An Exemption Available?

Before initiating the registration process, it is worth exploring whether an exemption from the registration requirements may be available. Through a combination of exemptions formally adopted by regulation and others created through administrative interpretation, several options may be available. First, there are a limited number of circumstances in which the CFTC has concluded that a trading vehicle was not a commodity pool within the meaning or intent of the Rules. These cases generally involve investment vehicles in which participation is limited to family members, several close personal and business associates of the manager, and individuals otherwise actively involved in the business of the fund. This exemption is obviously of limited utility since it is available only to funds with a very limited number

• f investors and which do not intend to solicit

additional investors. Section 4.13 of the Rules provides two alternative but similar bases for an exemption. If the general partner does not receive any compensation for managing the fund, it operates

• nly one pool and is not otherwise required to

register with the CFTC by virtue of other affiliations that the general partner or its principals may have, such person is exempt from the requirement to register as a commodity pool

• perator. Alternatively, a fund with less than

$200,000 in capital and fewer than 15 participants need not register. In recent years, requests have been made to the CFTC seeking no action relief for hedge funds that engage primarily in the trading of securities, which use futures on an infrequent basis and which commit a de minimis portion of the fund’s net assets as margin for commodity positions. Although several years ago it appeared that the staff of the CFTC was prepared to provide relief to funds that committed less than five percent of their net assets as margin for commodity positions, more recently, the staff has indicated that under current Rules, the appropriate avenue for obtaining a de minimis exemption is through a petition for rule making. Perhaps in response to this suggestion, on June 5, 1998 the NFA submitted a Petition For Rule

• Making. In its Petition, the NFA is seeking to

amend Rule 4.12 in order to exempt managers of hedge funds from commodity pool operator registration if they operate only vehicles that do a de minimis amount of futures transactions. To qualify for the exemption, the aggregate initial margin premiums required to establish futures positions for any pool may not exceed five percent of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses

• n any such contracts. Additional requirements

which would have to be satisfied in order to qualify for the proposed exemption are that the pool may not market participations to the public as a vehicle for trading in the commodity futures or commodity

• ptions

markets, the applicable

• ffering

memorandum must disclose to prospective participants the purposes of and the limitations on the scope of the commodity futures trading in which the pool will engage and a statement must be provided to each prospective participant and filed with the CFTC advising prospective participants that the manager is not registered as a commodity pool operator. Managers relying upon this exemption would nevertheless remain subject to the anti-fraud rules of the Commodity Exchange Act.

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In proposing the rule change, the NFA indicated that the purpose of the change is to free up NFA’s resources to better regulate and audit firms that are more directly involved in the futures

• markets. The Petition recognized that hedge funds

which do not commit more than a de minimis portion of their assets as margin for commodity futures positions and which do not market themselves to the public as vehicles for participating in the futures markets do not merit the amount of regulatory resources which are currently being dedicated to the hedge fund

• industry. While it is premature to predict whether

the CFTC will adopt the change as proposed, if adopted, it will clearly provide significant benefits to the hedge fund community. Unless and until this proposal is adopted, managers will have to rely on several less comprehensive exemptions. Under existing Section 4.12(b), an exemption is available to a fund which does not commit more than ten percent of the fair market value of its assets as margin for commodity positions and which trades commodity interests in a manner solely incidental to its securities trading activities. The relief available to a fund which relies upon this exemption is quite limited. The disclosure document for a 4.12(b) pool need not include the prior performance of the pool, account statements may be provided quarterly, rather than monthly, and the annual financial statements need not strictly comply in all respects with the CFTC’s requirements as to format and presentation. Far more useful is the exemption available pursuant to Section 4.7 of the Rules. A fund which qualifies for the exemption afforded by Section 4.7 is not required to submit a disclosure document to the CFTC or NFA for review before

• ffering interests in the fund to prospective
• participants. In addition, if a disclosure document

is utilized, it need not strictly comply with CFTC disclosure requirements, although the offering is ultimately subject to the CFTC anti-fraud rules. In addition, both the quarterly account statements and annual financial statements need not strictly comply with CFTC requirements. A Section 4.7 exempt pool is not limited in the percentage of its assets which may be committed as margin for commodity interest transactions. However, each investor in the fund must be a qualified eligible participant (“QEP”). The QEP definition is complex, particularly as applied to investors which are not natural persons and imposes a higher eligibility threshold on investors than would otherwise be applicable to a Regulation D private placement. In the case of a natural person, the investor must:

be an accredited investor ($1 million net

worth, or a minimum annual income of $200,000 in each of the two most recent years,

• r joint income with that person’s spouse in

excess of $300,000 with a reasonable expectation of reaching the same income level in the current year)

• wn securities having a market value of at least

$2 million, or $200,000 on deposit with a futures commission merchant in exchange specified initial margin and option premiums for commodity interest transactions, or a combination of the two. The QEP definition becomes especially complex in the case of a fund-of-funds investor. The fund-of-funds must:

satisfy the $2 million/$200,000 requirement

and must have assets in excess of $5 million

be able to represent that either the aggregate

investment by the fund-of-funds in all 4.7 exempt pools does not exceed ten percent of the fair market value of the assets of the fund-

• f-funds, or each of the investors in the fund-
• f-funds must be a QEP

. Non-U.S. persons generally qualify as QEPs without regard to the other tests. However, in the case of an offshore fund, if participation in the fund

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by U.S. persons exceeds ten percent of the net assets of the fund, it will not qualify as a non-U.S. person.

What About The Disclosure Document?

One of the more onerous requirements associated with being regulated as a commodity pool is the obligation to prepare and provide to prospective investors a disclosure document which complies with CFTC requirements. CFTC Rules specify in considerable detail the nature and scope

• f the disclosure which must be provided to
• investors. A significant portion of the required

disclosure consists of information which would not

• therwise be found in the offering memorandum if

it was prepared for a fund which does not trade commodity interests. Absent a 4.7 exemption, commodity pool disclosure documents must contain, among other things, certain specified legends and a break-even

• analysis. The break-even analysis is a tabular

presentation of the hypothetical amount of income and gain the pool would have to generate over 12 months in order to offset all expenses allocable or chargeable to the investor and enable the investor to recoup its initial investment upon withdrawal. The break-even analysis requires the manager to disclose every expense of the fund and to present the assumptions utilized in determining the break- even point. Often troubling to the hedge fund manager is the CFTC requirement that trading commissions be treated as an expense and included in the fund’s expense ratio. CFTC disclosure requirements are especially problematic for a fund-of-funds. A fund-of-funds is marketed by its manager on the basis that investors are investing in reliance upon the general partner’s ability to select managers and to make periodic changes in the allocation of the fund’s assets among managers. Notwithstanding this premise, the manager of a fund-of-funds is required to provide extensive information concerning the underlying managers with which the fund intends to invest and the strategies employed. At a minimum, the fund must identify:

the approximate percentage of the pool’s assets

that will be allocated to different strategies;

the types of securities which will be traded by

the managers; and

a description of the trading and investment

programs and policies which will be followed by the fund, including any material restrictions on trading. For any manager which is “a major investee pool,” i.e., an underlying fund in which the fund-of- funds intends to invest more than ten percent of its net assets, additional disclosure is required, including information concerning volatility, leverage, rates of return and length of time during which the manager has employed the strategy. In addition, a five-year business background must be provided for each principal of a major investee pool. If during the course of a year significant changes are made in a fund’s asset allocation which results in an investee pool becoming a major investee pool, or in a pool which was disclosed as a major investee pool falling below ten percent so that it is no longer a major investee pool, the offering document may become misleading and must be promptly amended. One of the anomalies of the regulatory scheme is that the term “major investee pool” applies only to an underlying fund which is itself a commodity pool. Because the CFTC does not have jurisdiction over underlying funds which do not employ commodities, the CFTC cannot compel a fund-of-funds to provide comparable disclosure about an investment in a fund over which it does not otherwise have jurisdiction. Therefore, it is possible to have a disclosure document which has extensive disclosure concerning a fund in which the

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fund-of-funds has invested a relatively small portion of its assets, but very limited information about a securities partnership in which the fund has invested significantly more than ten percent of its assets. Unless a fund intends to rely upon a 4.7 exemption, the disclosure document must be submitted to and approved by the NFA before the fund may accept subscriptions from investors. A new fund being organized must factor this review period into its timing in establishing an expected launch date for the fund. In addition, offering materials must be updated no less frequently than

• nce every nine months. At the time of each

updating, the revised offering materials must be resubmitted to the NFA for its approval.

Beware Of Other Requirements

Registered commodity pool operators are also subject to the accounting, recordkeeping and reporting requirements found in the Commodity Pool Rules. Among the more significant requirements is an obligation to provide quarterly (or monthly in the case of a pool which does not

• btain a Section 4.12(b) or Section 4.7 exemption)

account statements to all investors. The account statements must be in a format which is somewhat different than the format ordinarily used by a securities partnership. In addition, audited financial statements must be filed with the CFTC

• n an annual basis and provided to each investor.

A fund-of-funds is in a constant tug-of-war with the CFTC because of the requirement that audited financial statements be provided to pool participants and filed with the CFTC within 90 days of the end of the fund’s fiscal year. Because a fund-of-funds cannot complete its audit until it receives audited financials from each of its underlying funds, a fund-of-funds will often require up to 180 days to complete its audit. Past performance, if provided to investors, must be disclosed in the format mandated by CFTC Rules. In general, the rate of return must be provided on a monthly basis for five full years and year-to-date. All performance must be presented net of all fees, expenses and performance allocations. The largest monthly draw down during the five-year period and year-to-date and the worst “peak-to-valley” draw down during the same five-year period and year-to- date must also be disclosed. In the case of a fund which has less than a three-year operating history, the general partner must generally disclose the performance of any other pool operated by the general partner during the relevant five-year period. In addition, fund-of-funds managers should be aware that the performance of any major investee pool (a fund which is a commodity pool in which the fund has invested ten percent or more of its assets) must be presented in the disclosure document in accordance with the same rules. For new funds which do not yet have any performance history, the general partner may hope to use hypothetical past performance. While not prohibited, the use of hypothetical performance information is strongly discouraged by the NFA because of its potential to be misleading to prospective investors. As a result, it must be presented in compliance with several NFA releases which have been issued on this subject. Among

• ther things, the releases mandate the disclosure

which must be presented in order to describe the manner in which the performance has been determined, including the assumptions used. Certain legends must be prominently displayed to highlight the limitations of hypothetical performance information. A final burden associated with being registered as a commodity pool operator is the need to undergo periodic examinations by NFA

• examiners. At best, examinations are time

consuming and anxiety producing.

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To Register Or Not To Register

When confronted with the responsibilities imposed upon a registered commodity pool

• perator, a manager may find the obligations to be
• daunting. Instead of registering, the manager may

conclude that instruments which are not regulated by the CFTC (such as index options) can be an effective surrogate for the use of futures. For those who opt for registration, problems can best be avoided by preparing for the process by designating a principal of the firm to assume responsibility for

• ngoing compliance and ensuring that the person

designated familiarizes himself or herself with the requirements. If you have any questions regarding this or any

• ther investment management issue, please call George
• J. Mazin, Chair of the Investment Management

Practice Group, at (973) 597-2500.

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