SEC HEDGE FUND ROUNDTABLE
REMARKS OF JANE KANG THORPE
How does the CFTC's regulatory scheme affect hedge funds and hedge fund managers?
Thank you for the opportunity to appear on this panel assessing the current regulatory framework for hedge funds. The term "hedge fund" is not a term we use in our regulatory work at the Commodity Futures Trading Commission ("Commission" or "CFTC"). It is not defined in the Commodity Exchange Act ("CEA") or the Commission's regulations. However, that is not to say we are removed from the effects of hedge funds: to the extent that a hedge fund trades exchange-traded derivatives the hedge fund is a commodity pool, and its operator is subject to regulation under the CEA.
Who or What Do We Regulate? Commodity pools are collective investment vehicles that use futures, options on futures, or commodity options traded on regulated futures exchanges. The Commission regulates the operators of commodity pools and requires them to register as commodity pool operators ("CPOs"). The Commission does not directly regulate the commodity pools themselves. In addition, if the CPO relies on an external advisor that advisor must register as a commodity trading advisor ("CTA").
The fact that the CPO operates a scheme that invests in things other than futures and options does not alter the Commission's registration requirement. Mixed-purpose funds using futures or option products, even for hedging, have been deemed to be commodity pools and their operators generally have been required to register as CPOs. In addition, the statutory framework has no general exclusion from regulation for privately offered funds that is comparable to that under the securities laws. And historically, the Commission also has not recognized a de minimis exemption from CPO registration for a pool's operator based on a pool's low level of futures trading. In other words, neither the size of the futures element in the pool nor the sophistication of the pool's participants has provided a basis under the CEA to provide relief from the registration requirement.
CTAs are persons that advise others on the trading of futures and options. Certain entities, such as banks, registered investment advisers, and futures commission merchants ("FCMs"), are statutorily excluded from the CTA definition, if they render trading advice in a manner solely incidental to the conduct of their main business. In addition, those CTAs that do not furnish trading advice to more than 15 persons in a 12-month period and that do not hold themselves out to the public as CTAs are not required to register.
As of April 2003, there were 1,768 CPOs principally operating 1,895 pools and 779 registered CTAs principally advising clients.
How Do We Regulate? To answer this question one first needs to address the question of what the Commission is trying to achieve. The regulatory scheme for CPOs and CTAs is based on investor protection - it is designed to protect investors against fraud and other abuses. To achieve this purpose the CFTC sets forth registration and other requirements for CPOs and CTAs designed to ensure their qualifications and fitness. They must ensure that pool participants and advisory customers receive appropriate disclosures, which must be updated every nine-months. This will normally include information on the investment program, principal risk factors, past performance, fees and expenses, and conflicts of interest. CPOs also must provide periodic account statements as well as an annual audited financial statement for any pool they operate, and both CPOs and CTAs must comply with sales practice requirements as well as various reporting and recordkeeping requirements. Finally, they are subject to requirements on antifraud and anti-manipulation.
How is Compliance Conducted? CPOs and CTAs required to register as such with the CFTC generally must be members of the National Futures Association ("NFA"), an industry self-regulatory organization ("SRO"). In practice the CFTC has delegated many of its regulatory responsibilities in this area to the NFA, including the registration processing function, and review of disclosure documents and financial statements.
In addition, NFA has responsibility for conducting routine periodic examinations of compliance by CPOs and CTAs with CFTC and NFA requirements. CPOs and CTAs are examined on a three-year audit cycle, unless circumstances require otherwise.
What Regulatory Relief Is Available? Those that fall within the CEA's definition of CPO or CTA must register unless the Commission has excluded or exempted them from registration. Because none of these exceptions to registration is predicated on whether the pool at issue is a "hedge fund," the Commission does not have data on the percentage of hedge fund managers currently registered with and regulated by the Commission as CPOs or CTAs or, for that matter, the number that are not registered. However, based on Commission staff's experience, it appears that most - if not all - hedge fund operators or advisors that are registered as CPOs or CTAs are likely to conduct their activities pursuant to, in many cases, significant relief from the requirements that otherwise would apply to them.
CFTC rules provide certain registered CPOs with exemptions from disclosure, reporting, and recordkeeping requirements either because such disclosures would be duplicative or because of the sophistication of their investors. Rule 4.12(b) provides relief to registered CPOs that operate pools where the primary investment activity is in securities and the pool's commodity interest activity is limited and incidental to its securities trading.
Even broader relief is available to CPOs and CTAs that have highly sophisticated investors as participants. CFTC Rule 4.7 provides relief from various disclosure, reporting, and recordkeeping requirements for both registered CPOs and CTAs that operate or advise pools that are offered only to "qualified eligible persons." Registration data maintained by NFA indicates that over 50% of registered CPOs have claimed Rule 4.7 relief, and that approximately 75 percent of the pools currently operated by all registered CPOs are operated by entities that have claimed Rule 4.7 relief.
What Else Is Required of CPOs and CTAs? In describing the regulatory scheme governing CPOs you may recall that I did not mention a capital requirement for CPOs. Neither the CEA nor the CFTC's rules attempt to ensure the prudential safety and soundness of CPOs or their commodity pools. Nor does the CEA restrict the types of products a pool can trade. And the CFTC does not, except when specifically sought through special calls, receive detailed or current information about the over-the-counter trading of pools.
However, various protections, principally designed to ensure the financial integrity of FCMs, apply equally to all customer accounts carried by FCMs, including commodity pools. Also, to the extent hedge funds engage in commodity futures or option transactions on U.S. exchanges, they are covered by the CFTC's market surveillance tools that include speculative position limits and daily reporting by FCMs that carry accounts of large traders in exchange-traded contracts.
What percentage of hedge fund managers currently are registered with and regulated by the CFTC as CTAs or CPOs?
As I have mentioned, the term "hedge fund" is not recognized in the CEA, and we do not sort information on the status of a CPO as to whether it operates hedge funds or any other type of fund. While it is likely that many Rule 4.7-qualified CPOs operate vehicles that would be viewed as hedge funds, neither the CFTC nor NFA has data that would provide a reliable measure of how many hedge funds are operated by CPOs subject to the CFTC's jurisdiction. Similarly, we have no reliable data regarding the number of CTAs who advise hedge funds.
If the CFTC adopts the current rulemaking initiative, as proposed, with respect to exclusions from the definition of CPO and exceptions from registration as a CTA, will fewer hedge fund managers be registered with the CFTC? Has the CFTC done studies to quantify the effect of this proposed rule? If so, what are the findings?
Since the passage of the Commodity Futures Modernization Act of 2000 ("CFMA"), the Commission has been reviewing its regulatory framework to identify opportunities for modernization that benefit markets, intermediaries, and market participants. The Commission already has promulgated substantial rulemakings for futures exchanges and other trading facilities, and within the past year has turned its attention to modernizing regulations for intermediaries. The core consideration of the CFMA is to ensure that the level of regulation is appropriate to the activity and to the customers involved. I'd like to focus on a recent rule proposal that would expand Rule 4.13 that today provides an exemption from CPO registration for the operators of essentially "family, club or small pools."
In March of this year, the Commission proposed amendments to this rule to encourage and facilitate participation in the futures markets by additional collective investment vehicles and their advisers. One of those exemptions would be based on a de minimis amount of futures and options trading where participation is restricted to accredited investors. The other amendment would be based on a higher sophistication test, but without any restriction on the purpose or scope of the pool's futures trading. All non-natural person participants must be accredited investors, and all natural person participants must be registrants, insiders, qualified purchasers, or non-U.S. persons. The Commission would retain its jurisdiction over the exempt CPOs (and CTAs) and its antifraud authority.
It also should be noted that, because many of the investor qualification requirements in the proposed exemptions incorporate the SEC definitions of sophisticated persons, if the SEC raises its investor qualification standards, e.g., for who is an "accredited investor," the investor qualification standards in our Rule 4.13 exemptions automatically would increase.
In proposing these exemptions, Commission and NFA staff reviewed the audits of Rule 4.7 CPOs and found that the deficiencies uncovered rarely rose to a level that warranted disciplinary action. NFA indicated that it receives only two or three customer complaints per year regarding Rule 4.7 CPOs. Even more revealing, although the number of Rule 4.7 CPOs has increased by 482% in the past 10 years, NFA has brought only two enforcement actions involving the activities of Rule 4.7 CPOs.
The Commission requested public comment on these proposals. The comment period has closed, and Commission staff currently is reviewing the 31 comment letters filed. The comments were overwhelmingly favorable and many urged the Commission to adopt final rules, with various proposed modifications, as soon as possible.
The Commission already made the determination to exempt Rule 4.7-qualified CPOs from many of the disclosure and reporting requirements. And as I have noted, the results of NFA inspections of Rule 4.7-qualified CPOs do not evidence any material level of violations by such entities that would require the continuation of a registration and examination program.
Ultimately, the issue the Commission will need to address is: "does the continuation of the current regulatory regime deliver appreciably better degrees of investor protection, fraud prevention, or limitation of market abuse?" If the Commission cannot answer that in the affirmative, then perhaps final rulemaking consistent with the proposed rules would be warranted.
The Anticipated Effect? With the introduction of the amendments to Rule 4.13, Commission staff believes that all existing Rule 4.7-qualified CPOs would qualify under one of the exemptions from CPO registration. And approximately 50% of all active CPOs have filed Rule 4.7 notices. In addition to proposing registration relief, the CFTC has provided interim no-action relief so that entities that limit participation in pools they operate to accredited investors and agree to restrict their commodity trading could trade commodities without registering. As of May 2003, Commission staff has received 343 notices claiming the no-action relief embedded in the proposed rulemaking. Of these, 290 involved CPO registration relief.
In Summary: As you probably have been able to discern from my comments so far, CFTC regulation of commodity pools centers on issues of customer protection, the prohibiting of misleading means of solicitation, and requirements for the keeping of books and records - and it does not address issues of financial stability and impose such things as capital requirements or limitations on risk-taking. The Commission believes this approach is appropriate for its remit on both a practical and legal level. Practically, the transactions and investment strategies undertaken by these entities are extremely complex, and it would require the Commission or the NFA to have regiments of highly sophisticated risk managers to understand these strategies and systems - and equally sophisticated systems to be able to usefully regulate the risks. Legally, in the area of commodity pool operators, our statute focuses solely on the prohibition of fraud, unlike the regulation of FCMs, where the statute addresses financial integrity concerns and permits the Commission to impose capital requirements and risk assessment procedures.
To shift to a different regime for CPOs or CTAs (or to create a regime for hedge funds) would require substantive statutory amendment. It would again require the Commission to address a slightly different question: "would a more extensive regulatory regime be able to deliver appreciably better degrees of investor protection, fraud prevention, or limitation of market abuse?"
Thank you for the invitation to participate at this roundtable. I would be happy to respond to any questions you may have.