With respect to futures contracts, the SEC generally has taken the position that an amount equal to the full notional value of the contract must be held in the Segregated Account. However, with respect to cash-settled contracts, the SEC has, on an informal basis, allowed funds to segregate only the marked-to-market net obligations (i.e., the fund’s daily net liability) under the contracts, if any, rather than full notional value.
Since 1985, the CFTC has excluded mutual funds (which are registered with the SEC as investment companies, or RICs), insurance companies and ERISA plans that are “otherwise regulated” from regulation to avoid duplicate oversight. CFTC Rule 4.5 applied only to qualifying entities such as RICs if they used futures solely for bona fide hedging purposes or in other futures transactions if the aggregate initial margin and premiums required to establish such positions did not exceed 5% of the net asset value of the fund’s portfolio, after taking into account unrealized profits and losses on any such positions and excluding the amount by which such options were in-the-money at the time of purchase (the 5% Test); or if the RIC marketed itself as a futures product or as a vehicle for trading in or providing exposure to commodity interests (the Marketing Test). In 2003, the CFTC removed both of those tests for RICs. Now, a RIC could use futures in any amount and hold itself out in any way and still be excluded from the CFTC’s pool rules.
Not surprisingly, RICs began taking advantage of the expanded exclusion and a number of new managed futures RICs targeted at retail investors were launched. It created a regulatory anomaly with other retail managed futures products such as publicly offered futures funds (that were not RICs). The public futures funds were subject to detailed disclosure requirements, pre-filings with NFA, periodic reporting and other requirements, none of which were applicable to the managed futures RICs relying on Rule 4.5. Perhaps as a result of the regulators realizing that the de-regulation effort may have gone too far, or chagrined that they had no regulation over the fastest growing segment of the managed futures industry, the CFTC and National Futures Association (NFA) began efforts to re-instate the 5% Test and Marketing Test.
RICs that had launched managed futures funds opposed any additional regulation and correctly cited that although excluded from CFTC regulation, their funds were subject to SEC regulations for RICs. However, it didn’t seem to make sense to have a “regulatory arbitrage” opportunity for two virtually identical retail futures products, one involving a RIC with no CFTC or NFA regulation, and another with a public futures fund with significant regulation.
NFA took the lead role in speaking with the various segments of the RIC and managed futures industries to find a workable resolution. NFA assembled an informal group of representatives from the various factions to share their ideas in an attempt to forge a set of proposals to the CFTC. In April 2011, NFA submitted its comments on the Rule 4.5 amendments to the CFTC.
NFA recognized that there are RICs that use a significant number of futures (satisfy the 5% Test) but do not market themselves as managed futures products. In those cases, NFA proposed that the RIC’s registered investment adviser register with the CFTC as a pool operator, but that they be excluded from the CFTC’s Part 4 disclosure obligations. With the proliferation of futures equivalents (e.g., swaps), the calculation of the 5% is more complicated than prior to 2003 when the rule just counted initial futures margin. In addition, in advance of the adoption of the swaps rules and margin requirements, no one knows how much of a fund’s 5% will be taken up by margins.