If you think regulators should make the completion of Form CPO-PQR, the commodity equivalent of Form PF, a straightforward exercise for those managers already filing Form PF, think again. Despite the awkwardness, it seems unlikely the CFTC and the SEC will be doing much to overcome the differences between the two regulatory filings.
As fund managers were begrudgingly preparing for their Form PF (Private Fund) reporting obligations with the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC) announced it would like to see something similar from the Commodity Pool Operators (CPOs) and Commodity Trading Advisors (CTAs) it supervises.
Under CFTC Rule 4.13(a) (4) of the Commodity Exchange Act, private funds - including hedge fund managers – were exempt from CFTC registration under the “sophisticated investor exemption.” This exemption was rescinded in February 2012. Managers ensnared by the requirements must now become members of the National Futures Association (NFA), a self-regulatory body, if they wish to continue trading.
Investment managers – even those transacting in commodities and derivatives of commodities - were also excused from registering with the CFTC, as they were regulated by the SEC under the 1940 Investment Advisers Act. This too was scrapped.
The rationale behind the CFTC’s decisions was primarily a concern that SEC-registered investment advisers were inviting investors to purchase interests in de facto commodity pools. The regulator hoped its actions would narrow the restrictions by which firms could claim an exemption from registration with it.
The CFTC also argued the rules would bring about greater transparency into the activities of CPOs and CTAs operating in the futures and swaps markets, as well as prevent further regulatory arbitrage between itself and the SEC. In addition, the affected CPOs and CTAs must now file a Form CPO-PQR with the NFA. This is not proving to be a straightforward undertaking.
For a start, regulatory capture is not complete. The rules, which were enacted on 31 December 2012, do still allow for some exemptions. The CFTC permits private funds to claim what is known as a “de minimis” exemption.
A report by PricewaterhouseCoopers (PwC) states that a firm can avoid registration if the aggregate initial margin, or the premium attributable to commodity interests in each pool, does not exceed five per cent of the liquidation value of the portfolio of the pool, or the aggregate net notional value of the commodity interests does not exceed 100 per cent of the liquidation value of the portfolio of the pool.
This exemption is also conditional on the managers of the pool agreeing not to market the vehicle publicly – although this option is available to them under the Jump Start our Business Start-ups Act (the JOBS Act).
“The de minimis threshold is not high at all,” explains Gary Kaminsky, managing director for global regulatory and compliance at ConceptOne in New York. “There are firms trying to claim the de minimis exemption but we are not seeing fund managers liquidating their positions or avoiding certain swaps trades so as to avoid registering.”
Private funds claiming the exemption must re-confirm with the CFTC no more than 60 days before the end of the calendar year that their funds still meet the de minimis threshold. Registered investment companies must provide their re-confirmation 30 days prior to the end of the calendar year.
While it is relatively straightforward to ascertain whether a private fund meets the de minimis threshold requirements, it is less clear-cut for funds of hedge funds. Appendix A of Regulation 4.13(a)(3) used to provide a basis for managers of funds of hedge funds to claim the exemption to avoid registering as a CPO.
However, the guidance provided in Appendix A is very narrow, and failed to address the sheer diversity of hedge funds in which funds of hedge funds are actually invested. One of the exemption clauses was conditional on funds of hedge funds investing only in managers which trade below the de minimis threshold. This is not common.
The CFTC recognised this flaw and gave funds of hedge funds temporary relief to claim the exemption under Regulation 4.13(a)(3) from registering as a CPO until further clarity could be reached on the issue. A final ruling is still awaited. However, the temporary relief does mean funds of hedge funds do not need to file a Form CPO-PQR.
That said, in order to claim the relief, funds of hedge funds must prove to the CFTC that they do not know, and could not reasonably have known, that their indirect exposure to commodity interests from hedge funds exceeds levels specified in Regulation 4.5 or Regulation 4.13(a)(3) of the Commodity Exchange Act. The challenge facing most funds of hedge funds is that they do not have sufficient transparency into the positions of the underlying hedge funds to make that determination.
Emma Rodriguez-Ayala, general counsel and managing director at Mesirow Advanced Strategies, the $14 billion Chicago-based fund of hedge funds, explains the difficulty. "Our position at Mesirow Advanced Strategies - and it is a point we have made to the regulators - is that managers will generally not provide funds of hedge funds with the type of position-level transparency that they would need to help them identify whether they can claim the de minimis exemption,” she says. “Unless a fund of hedge funds invests with a hedge fund manager through a managed account, obtaining this data is very difficult. Even if a hedge fund manager provided the necessary transparency, it would not be provided on a real-time basis, so it would always be dated. So even if the fund of hedge funds manager discovers that it has breached the de minimis threshold because underlying hedge funds have themselves gone over the de minimis threshold, there is very little the fund of hedge funds could do about it, because it would be subject to the underlying hedge funds' redemption terms, and it might not be able to act for at least a quarter or even one year or longer with respect to some managers. Regulators are trying to find a way at solving this conundrum. The Managed Funds Association (MFA) and other industry associations have been working closely with regulators to come up with a solution. The MFA has asked the CFTC to provide a relief to funds of hedge funds, and I believe the regulators understand the issues we face. However, the CFTC has a huge amount on its plate at present and it is understandable that it is not prioritising this issue since they have already given funds of hedge funds managers a temporary relief."
Managers which do not attract even temporary relief have a more certain outlook. The reporting obligations apply with equal force to domestic and non-American managers that do not meet the de minimis thresholds outlined by the CFTC.
CPOs and CTAs affected must file a Form CPO-PQR and CTA-PR with the NFA at regular intervals. CPOs with less than $150 million in assets under management (AuM) must file Form CPO-PQR annually with the NFA through its EasyFile system. Those running more than $1.5 billion are required to submit it on a quarterly basis.
The data requested includes details of investments, borrowings, counterparty credit risk, trading and clearing activities, exposures by asset class, portfolio liquidity, and risk information such as Value at Risk (VaR) and stress tests.
CPO-PQR is in part modelled on Form NFA-PQR, a quarterly reporting document that registered CPOs have filed with the NFA since 2010, and there are similarities with Form PF. “The data requirements for Form CPO-PQR are not too dissimilar to those of Form PF,” explains Mike Megaw, global head of regulatory solutions at SS&C GlobeOp.
In fact, some Form PF filers are given a reprieve. Commodity pools that are not private funds are allowed by the CFTC to submit a Form PF as an alternative to Form CPO-PQR. CPOs managing between $150 million and $1.5 billion that are not covered by Form PF are required to fill in Schedule B in addition to Schedule A, while those running more than $1.5 billion must file Schedule C (see Table 1).
“If a CPO files Form PF quarterly with the SEC and includes data regarding its pools, it can rely on their Form PF to satisfy most of the demands of the CFTC for CPO-PQR,” says Gary Kaminksy. “However, dual registrants with the SEC and CFTC must still file Schedule A of Form CPO-PQR in the fourth quarter.”
* Note that form PF Filers only need to complete Schedule A of form CPO-PQR, but must also report a Schedule of Investments quarterly, as required by Form NFA-PQR. Source: PwC
“Filers of Form PF have incremental work to do for Form CPO-PQR,” adds Jonathan White, head of business development at Viteos Fund Services in New York. “It is simply about mapping out the additional data sets not contained in Form PF. It is not that onerous.”
Nonetheless, issues do remain. While Form PF and CPO-PQR are broadly similar, they are by no means fully harmonised. “A lot of the questions contained in Form CPO-PQR are similar to Form PF but it is not an identical reporting document,” says Mike Megaw. “In addition, the filing deadlines of Form PF and CPO-PQR for the most part are similar, which can be a challenge as you would have more information due at the same time. One example is that Form PF has a question on exposures in terms of listed and unlisted equities, and there are different categories about how firms bucket investments and how much is actually invested in each bucket. Meanwhile, Form CPO-PQR has different categories on this same question and the data required by the CFTC is more granular.”
Caren Rosch, compliance officer at SEI in Philadelphia, agrees. “Form CPO-PQR is in many ways more granular than Form PF,” she says. “For example, if a hedge fund has asset-backed security exposures, Form PF requires only the basic details of those exposures. Form CPO-PQR will want to know if those asset-backed security exposures are mortgage-related, commercial or residential, secured or unsecured, or senior, junior or mezzanine debt. The data set required by Form CPO-PQR may not always be routinely maintained by administrators since their fund accounting systems are often used to maintain only basic security attributes like industry classifications, quality ratings and standard asset groups used for financial statement purposes.”
Questions contained in the Form CPO-PQR are also open to multiple interpretations. There is no clarity, for example, on how the CFTC and NFA define total AuM. “Is total AuM gross assets?” asks Richard Casciani, assistant vice president at Cordium. “Can a filer use its Regulatory Assets under Management (RAuM), as defined by the SEC? The CFTC and NFA do not recognise the term RAuM but the SEC Form PF is based on RAuM, and the CFTC allows filers to substitute the Form PF for schedule B and Schedule C of the CPO-PQR. It would appear logical to use RAuM.”
The NFA has sought to provide clarity to Form CPO-PQR-filers. "Initially, the Form CPO-PQR asked for very specific information which many filers struggled to interpret,” says Rodriguez-Ayala. “Different law firms were taking a variety of positions when consulting clients. While the actual questions remain the same, when filers are compiling the document on-line, the NFA does provide useful guidance, and that is something the industry had requested.”
Other differences between the two regulatory reports include performance reporting, portfolio exposure measures and investment concentrations. Despite this, firms that have experience in filing Form PF can certainly leverage some of the knowledge acquired from that exercise when collecting and collating the data for Form CPO-PQR. However, the likelihood of the SEC and CFTC finding common ground on regulatory reporting remains a distant prospect. “I do not envisage the SEC and CFTC harmonising the two forms in the near future,” says Kaminsky.
Since managers submitting Form CPO PQR are also required to become members of the NFA, an application to register with the organisation has to be submitted on behalf of the firm (via Form 7-R) and a second application on behalf of its principals (Form 8-R).
Senior personnel at CPOs must also undergo a background check, and be subjected to finger- printing. One bemused chief compliance officer recalls having awkward conversations with senior staff, many of whom were somewhat irked at the ignominy of having to go to the nearest police station to have their fingerprints taken.
Senior personnel were also required to take an NFA Series 3 examination. This is a relatively straightforward test, and the NFA provides clear-cut guidance on its web site as to what is expected. Those required to sit the two hour and a half hour examination are nevertheless expected to have a comprehensive knowledge of market trends and US regulation.
Obviously, passing Series 3 adds to the compliance workload. Continuing disclosures do necessitate including information on returns and performance to the NFA, although these additional requirements apply to funds organised as mutual funds and not to private funds managing money on behalf of accredited investors.
One final question is what the CFTC will do with the data it receives. Much like Form PF, which is shared with the ten government agencies (including the SEC and CFTC) that make up the Financial Stability Oversight Council (FSOC) - the body mandated under the Dodd-Frank Act to monitor systemic risks in the American capital markets - Form CPO-PQR will be used by the CFTC in a broadly similar way.
“Just like the SEC with Form PF, I expect the CFTC will be using Form CPO-PQR as a tool for risk-based exams and investigations,” says Kaminsky. Rodriguez-Ayala agrees. “Nobody quite knows what the regulators are doing with the data,” she says. “Theoretically, Form CPO-PQR is designed to prevent build-ups of systemic risk and assist regulators in identifying potential build-ups of risk. Until filers report this information in a consistent manner, it seems like it would be a challenge for regulators to identify true systemic risks in the markets.”
One certainty is that the information will be used by the NFA for its own oversight purposes. “From what we have seen with our clients, the NFA has generally been taking a lead in terms of processing and analysing the Form CPO-PQR, and is the regulatory agency reaching out directly to the managers with inquiries,” says Caren Rosch.
While public knowledge of what the CFTC will do with the data remains limited, there is speculation the regulator is discussing the creation of a database to warehouse it. The idea was raised at a meeting of the CFTC Technology Advisory Committee. “According to the transcript of the meeting, Gary Barnett from the Division of Swap Dealer and Intermediary Oversight indicates that Form CPO-PQR is to be uploaded to the CFTC’s servers by the NFA as raw data,” says Casciani. “The CFTC is working with its Office of Data and Technology on developing a database for it.”