This article is the second in a series on a recent rule proposal by the U.S. Commodity Futures Trading Commission (“CFTC”) to amend CFTC Regulation 4.7.

Introduction

As detailed in an October 9 article at The BR Derivatives Report, the CFTC recently proposed amendments to CFTC Regulation 4.7. If adopted, these amendments will substantially change the disclosure and compliance oversight obligations of many commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”).

This article supplements the earlier article by offering a more detailed overview of the disclosure obligations under the CFTC’s proposal to amend CFTC Regulation 4.7. 

NFA Disclosure Document Guides for CPOs and CTAs: Understanding the Proposed 4.7 Disclosure Obligations by Considering Existing Disclosure Obligations for Non-QEPs

The recently proposed disclosure obligations under Regulation 4.7 are based upon existing requirements that apply to CPOs and CTAs offering services to prospective pool participants and clients that do not meet CFTC Regulation 4.7’s Qualified Eligible Person (“QEP”) requirements (such participants and clients, “Non-QEPs”).

To this end, it is useful to consider the disclosure document guides published by the National Futures Association (“NFA”) for CPOs (available here) and CTAs (available here) regarding the disclosure obligations that apply to Non-QEPs under CFTC regulations that are presently in effect.

In sum, understanding more about the existing disclosure requirements for CPOs and CTAs that offer pools and advisory services to Non-QEPs will aid in the understanding of the proposed amendments to CFTC Regulation 4.7.

The remainder of this article will focus on the disclosure obligations for CPOs and CTAs under the proposed rule amendments.

Principal Risk Factors: CPOs and CTAs

Proposed Regulation 4.7(b)(2)(i)(A) and Regulation 4.7(c)(1)(i)(B) will require a CPO or CTA, respectively, to disclose the principal risk factors of participation in the offered pool or advisory services, as applicable. This disclosure must include, without limitation:

1. Risks relating to volatility, leverage, liquidity, and counterparty creditworthiness, as applicable to the types of trading programs to be followed; and
2. Trading structures to be employed and investment activity (including retail forex and swap transactions) expected to be engaged in by the CPO in respect of an offered pool or the CTA in respect of any offered advisory services.

Proposed Regulation 4.7(b)(2)(i)(A) will apply to a CPO and is based upon the disclosure that must be made by CPOs to Non-QEPs under existing Regulation 4.24(g).

Proposed Regulation 4.7(c)(1)(i)(B) will apply to a CTA and is based upon the disclosure that must be made by CTAs to Non-QEPs under existing Regulation 4.34(g).

Investment Program, Custodians, and Use of Proceeds: CPOs Only

Proposed Regulation 4.7(b)(2)(i)(B) requires a CPO’s disclosure document to describe:

1. The types of commodity interests and other interests which the pool will trade;
2.  A description of the trading and investment programs and policies that will be followed by the offered pool;
3.  A summary description of the pool’s major CTAs, including their respective percentage allocations of the pool assets and a description of the nature and operation of the trading programs such CTAs will follow;
4.  A summary description of the pool’s major investee pools or funds (i.e., underlying pools or funds), including their respective percentage allocations of pool assets and a description of the nature and operation of such investee pools and funds; and
5. Certain use of proceeds information, including the manner in which the pool will fulfill its margin requirements, the percentage of the pool’s assets held in segregation pursuant to the Commodity Exchange Act, and information regarding to whom income from margin or security deposits will be paid.

Proposed Regulation 4.7(b)(2)(i)(B) is based upon the disclosure that must be made to Non-QEPs under existing Regulation 4.24(h).

Trading Program Description: CTAs Only

Proposed Regulation 4.7(c)(1)(i)(C) requires a CTA’s disclosure document to describe the CTA’s trading program, including:

1. The method chosen by the CTA concerning how futures commission merchants (“FCMs”) and/or retail foreign exchange dealers (“RFEDs”) carrying accounts the CTA manages treat offsetting positions pursuant to Regulation 1.46, if the method is other than to close out all offsetting positions or to close out offsetting positions on other than a first-in, first-out basis; and
2. The types of commodity interests and other interests the CTA intends to trade, with a description of any restrictions or limitations on such trading established by the CTA or otherwise.

Proposed Regulation 4.7(c)(1)(i)(C) is based upon the disclosure that must be made to Non-QEPs under existing Regulation 4.34(h).

Conflicts of Interest: CPOs and CTAs

CPO Disclosures

Proposed Regulation 4.7(b)(2)(i)(D) requires a CPO’s disclosure document to describe any actual or potential conflicts of interest regarding any aspect of the pool on the part of:

1. The CPO;
2. The pool’s trading manager, if any;
3. Any major CTA;
4. The CPO of any major investee pool (i.e., an underlying pool or fund);
5. Any principal of the foregoing; and
6. Any other person providing services to the pool (including FCMs and introducing brokers (each, an “IB”)), soliciting participants for the pool, acting as a counterparty to the pool’s retail forex or swap transactions, or acting as a swap dealer with respect to the pool. 

The disclosure document must also describe any other material conflict involving the pool.

Included in the description of all of the foregoing conflicts must be any arrangement whereby a person may benefit, directly or indirectly, from an investment of pool assets in investee pools or funds (i.e., underlying pools or funds) or other investments. 

Proposed Regulation 4.7(b)(2)(i)(D) is based upon the disclosure that must be made to Non-QEPs under existing Regulation 4.24(j).

CTA Disclosures

Proposed Regulation 4.7(c)(1)(i)(E) requires a CTA’s disclosure document to describe any actual or potential conflicts of interest regarding any aspect of their trading programs on the part of:

1. The CTA;
2. Any FCM and/or RFED with which the client will be required to maintain its commodity interest account;
3. Any IB through which the client will be required to introduce its account to an FCM and/or RFED; and
4. Any principal of the foregoing. 

Included in the description of such conflicts must be other material conflicts involving any aspect of the offered trading programs and any certain specified direct or indirect arrangements where the CTA or any principal thereof may benefit.

Proposed Regulation 4.7(c)(1)(i)(E) is based upon the disclosure that must be made to Non-QEPs under existing Regulation 4.34(j).

Past Performance of 4.7 Pools: CPOs and CTAs

CPOs

Proposed Regulation 4.7(b)(2)(i)(E) requires a CPO’s disclosure document to provide performance information for the 4.7 pool that complies with the requirements in CFTC Regulation 4.25 with one exception: the disclosures do not have to include information about the past performance for pools operated by the CPO other than the specific 4.7 pool to which the disclosure document relates. 

Proposed Regulation 4.7(b)(2)(i)(E) is based upon the disclosure that must be made to Non-QEPs under existing Regulation 4.25.

CTAs

Proposed Regulation 4.7(c)(1)(i)(F) requires a CTA’s disclosure document to provide performance information for all accounts directed by the CTA and each of its trading principals that complies with the requirements in CFTC Regulation 4.35. If neither the CTA nor its principals previously have directed any accounts, then the CTA must disclose this fact using one of three form disclosures listed in CFTC Regulation 4.35(b).

Proposed Regulation 4.7(c)(1)(i)(F) is based upon the disclosure that must be made to Non-QEPs under existing Regulation 4.35.

Persons to Be Identified: CTAs Only

Proposed Regulation 4.7(c)(1)(A) requires a CTA’s disclosure document to identify by name each principal of the CTA, the FCM and/or RFED with which the CTA will require its client to maintain an account, and the IB through which the CTA will require the client to introduce its account (or, if the client is free to choose which FCM, RFED, or IB it uses, then a statement to that effect).

Proposed Regulation 4.7(c)(1)(A) is based upon the disclosure that must be made to Non-QEPs under existing Regulation 4.34(e).

Conclusion: There Is Nothing New under the Sun…or at Least in the Proposed Amendments

Although the proposed amendments to CFTC Regulation 4.7 represent disclosure requirements that may be unfamiliar to many CPOs and CTAs offering products and advisory services to QEPs, the fact is that they are not new. Rather, as previously noted, the amendments are based upon existing requirements that apply to CPOs and CTAs offering products and services to Non-QEPs.

Therefore, the proposed amendments to CFTC Regulation 4.7 are best understood through the lens of these existing disclosure requirements. To this end, the NFA’s Disclosure Document Guides for CPOs (available here) and CTAs (available here) may be an extremely useful resource, especially for market participants considering the submission of comments on the proposed amendments to CFTC Regulation 4.7.

Finally, such prospective commenters may want to consider how the proposed amendments to CFTC Regulation 4.7 relate to other existing regulatory obligations, such as those that apply to an entity that dually registered as a CTA with the CFTC and an investment adviser with the Securities and Exchange Commission.

We will endeavor to do this, at least in part, in the next article in this series.