Regulatory musical chairs

Futures, Jun 2005 by Collins, Daniel P

Many of the hedge funds facing additional registration requirements trade futures. Can the CFTC and SEC work cooperatively to avoid doubling - and in some cases tripling - the regulatory burden on these funds?

Commodity pool operators always have been closely related to their regulatory cousins, commodity trading advisors and much of the managed futures universe falls in to the CPO/CTA category. But because of the intricacies of regulatory policy, hedge funds utilizing futures, even a little bit, had to be registered with the Commodity Futures Trading Commission (CFTC).

While seen as a burden, one which registrants long fought and eventually won freedom from the CFTC, with the Securities and Exchange Commission (SEC) requiring registration of investments advisors to hedge funds, the industry is gaining new found love for its former and current regulator.

The CFTC recently held a roundtable to discuss issues involving CPOs. Because the CFTC's once inclusive regulatory policy caused all managers using futures, even if it were not a significant part of their portfolios, to be registered, those managers are subject to dual regulation.

After a short history lesson, participants learned that this roundtable was not about CPOs, or CPOs as many of us have come to understand, but rather hedge funds. Turns out hedge funds are often CPOs and CPOs are often hedge funds (see "A big piece," page 65). Not only has the commodity been taken out of managed futures in favor of financial futures but many equity based funds fall into the CPO category. And now that they are no longer exempt from SEC registration they want to return to their roots.

While a cynic could see it as slightly disingenuous for managers, who lobbied a few short years ago to drop CFTC registration requirements, to beg off SEC registration requirements because they are already registered with the CFTC even though they have the ability to be exempt from those requirements, it makes perfect sense to them.

Lets be honest, managers and people in general prefer less regulation to more. When the CFTC opened the door to exemption, it gave a choice to managers. Given a choice between the CFTC, the regulator they know would exempt them, and the SEC, the regulator that has shown a great interest in overseeing them, managers vote with the CFTC.

However, arguments against CFTC registration have some merit because many of these funds are equity based hedge funds that sparingly use futures for hedging purposes. The CFTC agreed with those arguments two years ago and offered exemptions to registration for CPOs whose futures trading represented a minor part (less than 5%) of their portfolios. Of course that was prior to the SEC seeking hedge fund registration, thus the game has changed.

Many of the first CPOs grew from the managed futures space, backing the logic behind the industry's preferred structure. While hedge funds have been in existence since 1949, as recently as the early 1990s the managed futures and hedge fund universes mirrored each other in size. Hedge funds adopted the structure of managed futures private placements and grew exponentially with the bull equity markets. Indeed most of the world views managed futures as a hedge fund strategy; it is separate in the United States because of the split regulatory spheres of futures and equities. If a fund or pool offers interest in its fund, either public or private, it is a securities offering and comes under the jurisdiction of the SEC, even if it involves futures.

The CFTC and National Futures Association (NFA) have expertise in examining the offering material of CTA/CPOs, whereas the SEC does not, as it examines the offering material of retail directed mutual funds. Until recently, most equity-based hedge funds operated under exemptions to the Investment Advisors Act.

Of course many managers whose core business involves futures trading would be subject to the new SEC registration. James P. O'Hara, director of operational due diligence at Lighthouse Partners, noted at the roundtable that his firm's offering document was audited three times in a six-month period. "We would like to see more sharing of resources to limit audit procedures," O'Hara said.

CFTC Acting Chairman Sharon Brown-Hruska agrees. She supports exempting CFTC-registered CPOs from hedge fund registration and says the two agencies are making progress towards that goal. "In October of last year, the CFTC requested the SEC provide a broad exemption for CPOs and CTAs who are already registered with the CFTC." Though the SEC rejected the exemption at the time, Brown-Hruska said the two agencies were involved in discussions on a "primarily engaged test," adding, "I am cautiously optimistic that the CFTC and SEC will be able to announce an agreement later this spring."

The familiarity of the CFTC and NFA with CPO structures has allowed for relatively smooth interaction with funds. John Torrell, CFO and managing director of Tudor Investment Corp., stressed the importance of a good relationship with the regulator. "It has been very important for us to have a regulator who understands our markets, who is there to protect the integrity of the markets," said Torrell, whose fund manages $12 billion. "We feel comfortable calling the CFTC if we have an issue, [even] without having a lawyer present," Torrell added.