Securities Law Commentary November 2002 CFTC Expands the Ability of Mutual Funds, Banks, Insurance Companies and Pension Plans to Use Futures Contracts and Commodity Options for Other Than Hedging Purposes On October 28, 2002, the Commodity Futures Trading Commission (CFTC) proposed an amendment to CFTC Rule 4.5 that expands the ability of mutual funds, banks, insurance companies and pension plans to use futures and commodity options for other than bona fide hedging purposes without regulation as commodity pool operators. Significantly, the CFTC also announced that it is taking a no-action position to permit mutual funds and other eligible persons to rely on the proposed rule pending final action. CURRENT PROVISIONS OF RULE 4.5 A commodity pool operator (CPO) is a person operating an investment vehicle that trades in commodity futures and options contracts. CPOs are subject to a variety of requirements under the Commodity Exchange Act (CEA), including registration, disclosure, reporting and recordkeeping requirements. Rule 4.5 excludes from the definition of CPO persons that operate pools that: (1) are regulated by some other regulatory authority and (2) are not marketed as vehicles for trading in futures contract and commodity option markets. The following persons, and principals and employees thereof, are eligible to rely on Rule 4.5: n Registered investment companies (mutual funds), n n n Insurance companies subject to state regulation, Banks, trust companies and other financial depository institutions subject to federal or state regulation, and Trustees of, named fiduciaries of, and employers maintaining a pension plan that is subject to Title I of the Employee Retirement Income Security Act of 1974, as amended (ERISA). Each person listed above is excluded from the definition of CPO with respect to the operation of their respective qualifying entities. For a registered investment company, the qualifying entity is the registered investment company; for insurance companies, it is an insurance company separate account; for banks, trust companies and other financial depository institutions, it is the assets of any trust, custodial account or other separate unit of investment for which the bank is acting as a fiduciary with investment authority; and for trustees of pension plans, it is a pension plan subject to Title I of ERISA. To take advantage of the exclusion provided by Rule 4.5, the persons listed above must file a notice with the CFTC and the National Futures Association (NFA). This notice requires persons to represent that they will operate the related qualifying entity in compliance with certain restrictions. Kirkpatrick & Lockhart LLP The most significant of these restrictions is a restriction on the use of futures contracts and commodity options for other than bona fide hedging purposes. The qualifying entity must represent that it will limit the aggregate initial margin and premiums required to establish such non-bona fide hedging positions to 5% of the liquidation value of the qualifying entitys portfolio, after taking into account unrealized profits and unrealized losses on any such contracts into which it has entered. (In the case of an option that is in-the-money at the time of purchase, the in-the-money amount may be excluded in computing the 5% limitation.) THE “NOTIONAL TEST” The proposed amendment to Rule 4.5 creates a new Notional Test for other than bona fide hedging positions, which a qualifying entity may rely on as an alternative to the 5% test. Under the Notional Test, a qualifying entity must represent that the aggregate notional value of its non-bona fide hedging futures contract and commodity option positions does not exceed the liquidation value of its portfolio, after taking into account unrealized profits and unrealized losses on any such contracts it has entered into. The notional value is calculated for futures positions by multiplying the size of the contract, in contract units, by the current market price per unit. For options, it is calculated by multiplying the size of the contract, in contract units, by the strike price per unit. The CFTC noted that the Notional Test may permit greater use of non-hedge positions relating to equity but may be more restrictive than the 5% test in respect of the non-hedge positions relating to debt. The proposing release provides some examples of the calculation of the 5% test and the Notional Test. As a result of the proposed amendment to Rule 4.5 and the CFTCs no-action position permitting current reliance on the proposed amendment, qualifying entities can choose to comply with the Notional Test with respect to other than bona fide hedging positions in lieu of the 5% test without the need for making any additional filings or amended filings with the CFTC and NFA. The CFTC noted that its noaction position would expire when the CFTC takes final action on the rule proposal and that persons must then comply with the final rule. However, the CFTC stated that it would provide affected eligible persons and qualifying entities with sufficient time within which to comply with the criterion as adopted. Mutual fund sponsors who wish to rely on the Notional Test should consider whether they must amend their prospectuses or statements of additional information (SAI) to reflect the expanded permitted use of futures and options. In addition, mutual fund sponsors should be careful to consider whether reliance on the Notional Test would require any change to the mutual funds fundamental or nonfundamental investment restrictions. (Fundamental investment restrictions can only be changed by shareholder vote while changes to non-fundamental restrictions typically require only board approval.) Because, as the CFTC notes, the final amendments to Rule 4.5 may amend, supplement, or delete the 5% test and the proposed Notional Test, it may be prudent for mutual funds that have incorporated the provisions of the current Rule 4.5 in their investment restrictions to wait until the CFTC takes final action to avoid duplicative board action. CARY J. MEER 202.778.9107 [email protected] ARTHUR C. DELIBERT 202.778.9042 [email protected] CHARLES R. MILLS 202.778.9096 [email protected] MARC MEHRESPAND 202.778.9191 [email protected] Kirkpatrick & Lockhart LLP 2 Kirkpatrick & Lockhart LLP maintains one of the leading investment management practices in the United States, with over 60 lawyers devoting all or a substantial portion of their practice to this area. According to the April 2002 American Lawyer, K&L is a mutual funds powerhouse that represents more of the largest 25 investment company complexes and their affiliates than any other law firm. We represent mutual funds, insurance companies, broker-dealers, investment advisers, retirement plans, banks and trust companies, private funds, offshore funds and other financial institutions. We also regularly represent mutual fund distributors, independent directors of investment companies, retirement plans and service providers to the investment management industry. In addition, we frequently serve as outside counsel to industry associations on a variety of projects, including legislative and policy matters. We work with clients in connection with the full range of investment company industry products and activities, including all types of open-end and closed-end investment companies, funds of hedge funds, variable insurance products, private and offshore investment funds and unit investment trusts. Our practice involves all aspects of the investment company business: from organizing and registering open-end and closed-end funds, both as series and individual portfolios, to providing ongoing advice and representation to the funds and their advisers, directors and distributors. We invite you to contact one of the members of our investment management practice, listed below, for additional assistance. You may also visit our website at www.kl.com for more information, or send general inquiries via email to [email protected] BOSTON Michael S. Caccese Philip J. Fina Mark P. Goshko (617) 2613133 [email protected] (617) 2613156 [email protected] (617) 2613163 [email protected] LOS ANGELES William P. Wade (310) 5525071 [email protected] NEW YORK Beth R. Kramer Richard D. Marshall (212) 5364024 [email protected] (212) 5363941 [email protected] Robert M. McLaughlin (212) 5363924 [email protected] Loren Schechter (212) 5364008 [email protected] SAN FRANCISCO Eilleen M. Clavere David Mishel Richard M. Phillips (415) 2491047 [email protected] (415) 2491015 [email protected] (415) 2491010 [email protected] WASHINGTON Clifford J. Alexander Diane E. Ambler Catherine S. Bardsley Arthur J. Brown Arthur C. Delibert Robert C. Hacker Benjamin J. Haskin Kathy Kresch Ingber Rebecca H. Laird Thomas M. Leahey Cary J. Meer R. Charles Miller Dean E. Miller R. Darrell Mounts C. Dirk Peterson Alan C. Porter Theodore L. Press Robert H. Rosenblum William A. Schmidt Lynn A. Schweinfurth Donald W. Smith Robert A. Wittie Robert J. 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This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. © 2002 KIRKPATRICK & LOCKHART LLP. ALL RIGHTS RESERVED.