Recently, there has been substantial growth in mutual funds utilizing managed-futures-based strategies. The number of distinct managed futures mutual funds doubled to 24 in 2011, according to Morningstar Inc. The funds represent a revolutionary advance in the product mix in managed futures. Once regulatory roadblocks are lifted, the growth of mutual fund products will escalate even more.
Some of the principal attractions to managed futures mutual funds for investors and financial intermediaries are that, in addition to offering exposure to the asset class, they offer daily liquidity. Also, they can be sold, like traditional mutual funds, through omnibus “supermarket” arrangements using electronic “point and click” trading, without the need for investors to fill out subscription documents or applications. However, the regulatory landscape for these products is evolving quickly.
Therefore, it is important that sponsors looking to launch managed futures mutual funds understand the regulatory issues. Recent rulemaking proposals by the Commodity Futures Trading Commission (CFTC) and recent Internal Revenue Service (IRS) policy changes could affect these products (see “The tax man cometh,” last page).
Managed futures mutual funds are regulated by both the CFTC and, pursuant to the 1940 Act, by the Securities and Exchange Commission (SEC). The sponsors of these investment products must understand the restrictions under the 1940 Act that relate to trading futures contracts in a mutual fund. Because of these unique issues, it also is important that compliance officers of these funds (and their managers) implement appropriate policies and procedures designed to prevent violations of applicable law. To further complicate matters, much of the law in this area is uncertain.
Section 18 of the 1940 Act limits the ability of investment companies to issue senior securities, which primarily is intended to restrict an investment company’s ability to create leverage. The SEC has viewed various trading practices, including futures trading, as potentially involving the issuance of senior securities.
To address the leveraging concerns presented by such transactions, the SEC has established guidelines. These generally are set out in no-action letters as well as informal staff positions. They typically require the establishment and maintenance of a segregated account with the investment company’s custodian containing sufficient assets to cover the obligation arising from a particular transaction (Segregated Account). The assets in a Segregated Account must be liquid (and may include equity securities and debt securities of any grade) and marked-to-market daily, and may not be used to cover other obligations.
The SEC has reasoned that a Segregated Account will function as a practical limit on the amount of leverage an investment company may undertake and ensure the availability of adequate funds to meet the obligations arising from such transactions.
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.
The second operating restriction that the CFTC wants to restore to Rule 4.5 is the Marketing Test. In other words, a fund sponsor would not qualify for the exclusion in Rule 4.5 if it markets the fund as a managed futures product or as a vehicle for getting investment exposure to the commodities or futures markets. Certain funds have clearly marketed themselves as futures funds, whether because of the name of the fund or its stated investment objective. For other funds, it is not as clear whether they satisfy the Marketing Test (see “Pass or fail,” below).
If the proposed revisions to Rule 4.5 are adopted, an instrument that calls itself a managed futures fund would have to comply with the CFTC’s Part 4 commodity pool rules. The most difficult challenge will be to “harmonize” those CFTC rules with the requirements under the SEC’s rules for RICs. Although there are some logistic differences in the areas of reporting to investors, delivery of the prospectus and recordkeeping, those easily can be resolved by the CFTC’s exemptive authority.
The hardest area to harmonize will be the content of the disclosures to investors. The SEC and CFTC’s disclosure practices are similar but not identical, and in some areas, they conflict. The SEC requires disclosure of the dollar amount of expenses an investor will pay after one, three, five and 10 years of investment, assuming a 5% return. However, the CFTC requires a “breakeven” disclosure of the percentage return that a fund must realize in the first 12 months of operations to recoup all fees and expenses during that period. The best example of a conflict between the two has to do with past performance results. The SEC prohibits the inclusion of past performance of the fund sponsor (unless the fund is substantially similar to the other fund). However, the CFTC requires all of such past performance, whether substantially similar or not. The CFTC could exempt RICs from the past performance disclosure obligations (and from any other rule that is inconsistent or conflicts with the SEC’s rule), but it would detract from the CFTC’s goal of regulating these retail futures products.
Another significant difference between the SEC and CFTC is the way that the prospectus/disclosure document is amended. When filing an amendment with the SEC (that does not trigger the re-filing of a registration statement), the amendment is effective upon filing without staff review or comment. By contrast, all amendments filed with the CFTC (actually NFA, to whom the function was delegated) are reviewed by NFA (even those with immaterial changes). While every effort is made by NFA to accommodate a fund’s schedule, the volume of filings and the detailed review of them that is mandated by the CFTC frequently causes significant delays before a document can be distributed to fund investors. Because RICs have daily purchases and redemptions, it is critical that all updated prospectuses be available to investors without delay. The CFTC could require RICs that are not eligible for Rule 4.5 to file all amendments with NFA but make such amendments available to investors immediately without waiting for staff comments.
The CFTC hosted a “roundtable” on July 5, 2011 for the various interested parties to share their views and provide additional information to the staff during their deliberations on the rule proposal. More than 80 industry participants have submitted comments to the proposed changes to Rule 4.5, many of them critical in one way or another.
It is not clear that the SEC is willing to exempt or modify its rules as part of any harmonization with the CFTC in connection with adoption of a revised Part 4.5. Thus, the burden to mesh the rules may rest solely on the CFTC.
The goal of the CFTC and NFA in amending Rule 4.5 is laudable — to have a level playing field when it comes to regulating retail managed futures products. The rub is that the uneven playing field right now is just fine with the existing funds. It is hoped that the CFTC will work with the industry to address operational concerns prior to enacting any final rulemaking.
Many persons in the industry expected that the CFTC would have adopted the Rule 4.5 changes by now. The delay could be a matter of allocation of staff resources. No doubt the staff is swamped with finalizing the Dodd-Frank swap rules, and then something called MF Global came along.
The tax man cometh
In addition to the SEC regulations, the Internal Revenue Code (IRC) also causes unique issues for managed futures mutual funds.
For example, mutual funds avoid corporate-level tax by qualifying as “regulated investment companies” under the IRC. And under the “90% Test,” at least 90% of a regulated investment company’s gross income each year must come from dividends, interest, gains from the sale of stock, securities or foreign currencies, certain payments with respect to securities loans and other income derived with respect to the investment company’s business of investing in stocks, securities or currencies. The IRS has ruled that income from a fund’s investments in commodity futures contracts does not constitute qualifying income for purposes of the 90% test.
To address this tax constraint, the mutual fund industry has come up with an alternative structure: Under the diversification rules applicable to an investment company, that company is permitted to invest up to 25% of its assets in a wholly owned foreign subsidiary corporation. These subsidiaries, which are usually organized as Cayman Islands exempted companies, typically hold futures contracts, swap contracts and fixed income securities that serve as collateral. Generally there are no tax limitations on what they can hold. The income and gain recognized by the subsidiary each year generally constitutes ordinary income for the investment company under the “subpart F” rules applicable to “controlled foreign corporations” whether or not the subsidiary makes any actual distributions to the investment company. It should be noted that the income from the foreign subsidiary will be ordinary income for the investment company, which will result ultimately in ordinary income to the investment company shareholders when they receive their distributions. Thus, the structure is not as tax-advantageous as a partnership structure under which the partnership can take advantage of the 60-40 rule for gains on regulated futures contracts under Section 1256 of the Code, which results in 60% of the gains flowing out to investors at long-term capital gains rates.
The IRS has issued 29 separate private letter rulings to individual funds to the effect that the subpart F income resulting from these subsidiaries will be qualifying income for purposes of the 90% test even though the income of the subsidiaries if earned directly by the investment company would not be qualifying income. But the IRS recently suspended its issuance of any further private letter rulings on this subject, and is working on preparing published guidance that can be used by all taxpayers. It is anticipated that the official guidance that is ultimately issued will reach the same conclusion as did the private letter rulings, although that is not a sure thing.
Joshua Deringer and David Matteson are partners in the Investment Management Practice Group at Drinker Biddle & Reath LLP. Stephen D.D. Hamilton is a tax partner at Drinker Biddle.