New CFTC Rule 4.7 Changes Have Private Funds Industry Breathing a Sigh of Relief

The US Commodity Futures Trading Commission on September 12 issued final changes to Rule 4.7 that were limited to an increase in the “Portfolio Requirement” threshold contained in the definition of “qualified eligible person” (QEP) and other less controversial changes. The CFTC did not approve the sweeping changes to Rule 4.7 it had proposed that would have dramatically increased regulatory burdens and cut back on the prior regulatory exemptions available to Rule 4.7 exempt CPOs and CTAs.[1]

BACKGROUND

In October 2023, the Commodity Futures Trading Commission (CFTC or Commission) proposed an overhaul to Rule 4.7 of the Commodity Exchange Act that would have subjected CPOs and CTAs to prescriptive disclosure requirements, including past performance disclosure, annual updates to offering memoranda for CPOs, and increased scrutiny during National Futures Association examinations.

Nearly a year after that initial proposal, and after extensive industry comment on the proposal, the CFTC seemingly made an about-face and adopted a diluted version of the proposal—a favorable outcome for 4.7 exempt CPOs/CTAs that would have been subject to the prescriptive requirements. However, they remain subject to the requirement that any offering memorandum or brochure they provide to investors include all disclosures necessary to make the information contained therein, in the context in which it is furnished, not misleading.

The CFTC’s rationale for the initial proposal was the concern that natural person investors would not be able to demand the same level of transparency afforded other larger or institutional investors. In fact, when the initial proposal was first published, the CFTC publicly articulated its belief that such a perceived disparity could result in CPOs and CTAs seeking capital from individuals who may not have the tools to monitor the CPOs’ and CTAs’ risk management and other controls as sufficiently as larger institutional investors. Commenters generally disagreed with the Commission for the need for a disclosure regime for 4.7 pools and exempt accounts. Commenters noted that advisory clients can decline the 4.7 status. They also argued that the perceived disparity in information could be mitigated if the Commission adopted a higher QEP threshold.

THE UPDATED QEP DEFINITION

Under the prior definition of a QEP, certain persons (including natural persons who are accredited investors, among others) must meet one of two thresholds or a combination of the two, including that such persons: (1) own securities (including pool participations) of unaffiliated issuers and other investments with an aggregate market value of at least $2 million (the Securities Test); (2) have on deposit with a futures commission merchant for its own account at any time during the preceding six months at least $200,000 in exchange-specified initial margin and option premiums, with minimum security deposits for retail forex transactions, for commodity interests (the Initial Margin and Premium Test); or (3) own a portfolio with a combination of the Securities Test and Initial Margin and Premium Test that meets or exceeds 100% when expressed as a percentage of the requirements (i.e., $1 million in securities and $100,000 in initial margin and option premiums).

The newly adopted Portfolio Requirement doubles the amounts of the two thresholds: The Securities Test will be set at $4 million and the Initial Margin and Premium Test will be set at $400,000. The CFTC will continue to allow a person to meet the Portfolio Requirement by a combination of the two tests adding up to 100%.

The Commission reasoned that doubling the Portfolio Requirement (which was adopted in 1992) would account for inflation and align the requirement with the CFTC’s original intent. By increasing the Portfolio Requirement, the Commission believes it can continue differentiating between retail investors and sophisticated investors who do not need the disclosures and other customer protections that are available to non-QEP investors or advisory clients. Although some commenters noted that the new QEP standard would be more difficult for natural persons (despite being accredited investors) to satisfy, the CFTC believes that this result is acceptable because the QEP standard was always intended to be an additional condition of eligibility.

CODIFICATION OF THE ACCOUNT STATEMENT DEADLINE

The final rules also adopt a 45-day deadline for monthly account statements for CPOs of fund-of-funds that do not have the necessary information to prepare quarterly account statements within 30 days of the end of the period. The new rule codifies exemptive relief that CFTC staff has historically provided upon request to streamline the availability of the relief, provide consistency, and eliminate the need to request (or, for staff, to consider) specific relief for something that is standardized.

NEXT STEPS

The CFTC is providing six months from the rules’ publication in the Federal Register (the Compliance Date) for CPOs and CTAs to come into compliance with the new Portfolio Requirement, although CPOs of fund-of-funds can start relying on the account statement reporting schedule 60 days after the rules are published in the Federal Register.

To qualify as a 4.7 Exempt CPO/CTA, all investors that invest in a fund or managed account beginning as of the Compliance Date must now meet the higher QEP threshold. Ahead of the Compliance Date, 4.7 Exempt CPOs/CTAs should update their subscription agreements or management agreements to reflect the new Portfolio Requirement and consider implications of the increased standard for their investor base. CPOs or CTAs will not be required to redeem an existing QEP investor or terminate an existing client’s relationship if such investor or client does not meet the new Portfolio Requirement since an investor’s or client’s QEP status is determined at the time of sale of a pool participation in a 4.7 pool or the opening of a 4.7 exempt account (which would have been made before the increase to the Portfolio Requirement). After the Compliance Date a CPO or CTA may not, however, sell additional participations or open additional exempt accounts for those who no longer meet the new Portfolio Requirement or no longer otherwise qualify as QEPs.

APPENDIX

The following persons must satisfy the Portfolio Requirement to satisfy the QEP standard:

1. an investment company registered under the Investment Company Act or a business development company as defined in Section 2(a)(48) of such Act not formed for the specific purpose of either investing in the exempt pool or opening an exempt account;
2. a bank as defined in Section 3(a)(2) of the Securities Act of 1933 (the Securities Act) or any savings and loan association or other institution as defined in Section 3(a)(5)(A) of the Securities Act acting for its own account or for the account of a QEP;
3. an insurance company as defined in Section 2(13) of the Securities Act acting for its own account or for the account of a QEP;
4. a plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5 million;
5. an employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 (the investment decision must be made by a plan fiduciary, as defined in Section 3(21) of such Act, which is a bank, savings and loan association, insurance company, or registered investment adviser; or that the employee benefit plan has total assets in excess of $5 million; or, if the plan is self-directed, that investment decisions are made solely by persons that are QEPs);
6. a private business development company as defined in Section 202(a)(22) of the Investment Advisers Act;
7. an organization described in Section 501(c)(3) of the Internal Revenue Code, with total assets in excess of $5 million;
8. a corporation, Massachusetts or similar business trust, or partnership, limited liability company or similar business venture, other than a pool, which has total assets in excess of $5 million, and is not formed for the specific purpose of either participating in the exempt pool or opening an exempt account;
9. a natural person whose individual net worth, or joint net worth with that person's spouse at the time of either his purchase in the exempt pool or his opening of an exempt account would qualify them as an accredited investor as defined in 17 C.F.R. § 230.501(a)(5);
10. a natural person who would qualify as an accredited investor as defined in 17 C.F.R. § 203.501(a)(6);
11. a pool, trust, insurance company separate account or bank collective trust, with total assets in excess of $5 million, not formed for the specific purpose of either participating in the exempt pool or opening an exempt account, and whose participation in the exempt pool or investment in the exempt account is directed by a QEP; or
12. except as provided for the governmental plans refenced in (3), above, if otherwise authorized by law to engage in such transactions, a governmental entity (including the United States, a state, or a foreign government) or political subdivision thereof, or a multinational or supranational entity or an instrumentality, agency, or department of any of the foregoing.