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.