The growing interest in alternative investments in recent years has enhanced the demand for Commodity Pool Operators (CPOs) and Commodity Trading Advisors (CTAs). A growing number of CPOs and CTAs have been created to meet that demand. If you are thinking about creating a CTA or CPO, you should be aware that you will be participating in a highly regulated industry, and the ability to understand and execute your regulatory due diligence can be as important as creating and executing a profitable trading program.
Perhaps the first thing you must overcome is the usage of the word commodity. When the applicable regulations were created, the words commodity and future were synonymous. Today CTAs and CPOs access the entire universe of futures and options on futures, only a small percentage of which (volume wise) can be termed commodities.
There are a number of regulatory requirements and potential pitfalls that require careful consideration.
Commodity Trading Advisors
Officially, the Commodity Exchange Act (CEA) of 1936 defines a CTA as:
“[A]ny person who, for compensation or profit, engages in the business of advising others, either directly or through publications, writings or electronic media, as to the value of or the advisability of trading in any contract of sale of a commodity for future delivery made or to be made on or subject to the rules of a contract market, any commodity option authorized under Section 4c of the Act... or who, for compensation or profit, and as part of a regular business, issues or promulgates analysis or reports concerning any of the foregoing...”
This definition is a bit unwieldy, but in general, most CTAs are individuals or companies that are paid to trade futures and options accounts for clients, including commodity pools, corporations and individual investors. A CTA also might be an individual or company that provides futures trading advice to others for profit, either in the form of individualized advice or perhaps, a newsletter or Internet site.
With few exceptions, a CTA must register with the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA). Advisors that have provided advice to 15 or fewer clients during the last 12 months and do not hold themselves out to the public as CTAs, however, are exempt from registration.
Advisors who are involved in certain specified businesses also may be exempt from registration. This includes dealers, processors, brokers, insurance companies subject to state regulation, certain professionals listed in the CEA, and certain futures professionals who are already registered in another capacity and whose advice is solely incidental to their principal profession, such as an associated person employed by a futures commission merchant (FCM). An advisor who gives trading advice solely to his own pool does not have to be registered as a CTA if the person is registered as a CPO, or an associate of the CPO.
The CFTC requires CTAs to provide each prospective client with a detailed disclosure document at or before the time a trading agreement is solicited or entered into. In addition, the CTA must obtain a signed and dated acknowledgement from the prospective client noting that the client has received the disclosure document. The disclosure document must follow a prescribed format and contain certain specific items (see “Making a list,”).
The NFA is now responsible for reviewing disclosure documents for CTAs before they are used. Copies of disclosure documents must be submitted to the NFA, either by mail or electronically and the CTA must wait to receive a letter of acceptance from the NFA, confirming that the document can be used. Once an initial disclosure document has been accepted, members may use the NFA’s instant filing procedure. Copies of subsequent amendments or updated documents also must be submitted to the NFA using the same procedures. If the CTA knows or should know that the disclosure document is materially inaccurate or incomplete in any respect, it must distribute the correction within 21 calendar days and file a copy of the amendment with the NFA.
CTA Record-Keeping and Audits
NFA Regulation 431 requires CTAs to maintain certain records, including:
Itemized daily records for each transaction with the pertinent execution details.
Daily and monthly trade confirmations.
Basic background information concerning clients, including discretionary trading documentation and advisory agreements.
All marketing information, regardless of whether it produced clients or not.
New CTAs can expect to be audited by the NFA within six to twelve months of registration. After that, audits will typically occur every two years. Those audits generally focus on six major areas:
• General information.
• Disclosure documents.
• Customer complaints and advertising.
• Fees and block order execution.
• Performance record testing.
Investment Advisor Rules
Finally, CTAs need to be cognizant of federal and state investment advisor rules. In general, larger CTAs may be subject to Securities and Exchange Commission (SEC) regulation as an investment advisor; whereas, smaller CTAs may be subject only to state regulation. These regulations vary by jurisdiction, but any person planning to become a CTA should be aware of this potential additional layer of regulation.
Commodity Pool Operators
A commodity pool is an investment vehicle that pools the funds of several investors for the purpose of trading futures and options. A commodity pool can take on a variety of forms and depending on the attributes of a particular pool, it may be subject to regulation by the CFTC, NFA, SEC, and/or various state agencies.
Commodity pools offer investors great flexibility. In contrast to an individually managed futures account, which requires a large individual investment, an investor can participate in a commodity pool for a relatively small investment. This allows investors with moderate means to participate in commodities and futures investments, and it gives large investors the opportunity to diversify their holdings by enabling them to invest in several different commodity pools rather than just one individual account. In addition, the structure of a commodity pool allows investors to limit their liability to the amount of their individual contribution.
Commodity pools are generally organized as limited partnerships or limited liability companies. In a limited partnership, a CPO typically acts as the general partner and the individual investors are the limited partners. In a limited liability company, a CPO typically acts as the manager or managing member, and the individual investors are members. These and other flow-through structures allow commodity pools to distribute earnings directly to investors without having the fund pay taxes.
The CEA defines a CPOs as:
“[A]ny person engaged in a business which is of the nature of an investment trust, syndicate or similar form of enterprise and who, in connection therewith, solicits, accepts or receives from others, funds, securities, or property, either directly or through capital contributions, the sale of stock or other forms of securities, or otherwise, for the purpose of trading in any commodity for future delivery or commodity option on or subject to the rules of any contract market.”
The Act narrows the definition by excluding any person who operates certain “otherwise regulated” entities, such as registered investment companies, insurance company separate accounts, bank trust funds and certain pension plans.
A CPO is required to register with the CFTC and the NFA, unless the CPO operates a pool pursuant to one of the exemptions. Entities and persons not required to register as a CPO under Rules 4.5 and 4.13 include: Entities that are already regulated by other agencies, such as a banks, insurance companies or registered investment companies; CPOs that operate small pools that have received less than $400,000 in aggregate capital contributions and that have no more than 15 participants; and CPOs that operate pools only open to persons who demonstrate an extraordinary level of sophistication or high net worth. These sophisticated or wealthy individuals are known as qualified eligible participants.
Registered CPOs must provide prospective pool participants with a disclosure document before or upon delivering the pool subscription agreement to the participant. A prospective client must sign an acknowledgement of the disclosure before the CPO can accept the prospect as a participant in the pool.
If the pool has a three-year operating history, and at least 75% of the pool’s contributions were made by people unaffiliated with the CPO, CTA or trading manager, then the performance of the pool is all that must be disclosed. If the pool has less than a three-year operating period, additional disclosure requirements apply.
Record Keeping and Reporting
As in any regulated investment vehicle, CPOs are required to make and retain certain books and records. CPOs exempted from registering with the CFTC or the NFA, however, are also exempted from many of these recordkeeping requirements.
In addition, CPOs must provide pool participants with monthly statements, unless the pool’s assets are less than $500,000, in which case CPOs are only required to provide quarterly statements. The statements must include a Statement of Income and Statement of Changes in Net Asset Value for the prescribed period. CPOs also must use these statements to disclose any additional information regarding material business dealings that have not been previously disclosed.
Aside from direct regulation by the CFTC and NFA, CPOs also must navigate a web of federal securities laws and related state laws, including a number of SEC regulations.
Individuals interested in creating a CTA or CPO should consult a qualified legal professional for a detailed explanation of all regulatory responsibilities.
Beau T. Greiman is a partner in the Chicago law firm of Levenfeld Pearlstein LLC. He has extensive experience representing professionals involved in the futures industry, including CPOs and CTAs. He can be reached by e-mail at firstname.lastname@example.org.