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  • Statement of Concurrence, Commodity Pool Operators and Commodity Trading Advisors: Amendments to Compliance Obligations

    Commissioner Scott D. O’Malia

    February 2, 2012

    Earlier this week, on January 31st, all futures customers of MF Global Inc. (“MF Global”), the futures commission merchant that collapsed and left a complex trail of cash movements resulting in a $600 million to $1.2 billion shortfall in segregated futures customer funds, are required to submit their paperwork to secure their claims against the bankruptcy estate. As of today, U.S. futures customers have received just 72 cents on the dollar. While MF Global’s failure resulted from over-leverage, it ultimately became too toxic to be sold, and bankruptcy became the only viable option when it came to light that it could not account for – what was at that time – an estimated $700 million deficit in segregated futures customer funds. This shortfall not only has devastatingly impacted customers, but it also punished shareholders and rocked the foundation of our customer protection regime.

    I take very seriously the Commodity Futures Trading Commission’s (“CFTC” or “Commission”) customer protection mission and responsibilities, especially with regard to retail customers. I therefore support the Commission’s adoption of amendments to its part 4 regulations which, among other things, modify the criteria for claiming an exclusion from the definition of commodity pool operator (“CPO”) under regulation 4.5 and rescind the exemption from CPO registration provided in regulation 4.13(a)(4).

    There was much industry opposition to the proposed adoption of these amendments. Some argued that registration under the Commodity Exchange Act provides no tangible benefit to the Commission or investors because registered investment companies who are currently taking advantage of the regulation 4.5 exclusion are already subject to regulation by the Securities and Exchange Commission (“SEC”). Others argued that these amendments are not required rulemakings under the Dodd-Frank Act and should not be addressed at this time. Notably, however, no one has questioned that the Commission has a regulatory interest in overseeing entities which are actively engaging in derivatives trading, and providing exposure to retail customers in these markets.

    The financial crisis, and now the collapse of MF Global, highlights the need for more accessible and effective customer protection measures. The Dodd-Frank Act did not include CFTC-regulated products under the umbrella of “consumer financial products or services” regulated by the new Consumer Financial Protection Bureau (CFPB), and indeed persons regulated by the CFTC (as well as persons regulated by the SEC) are specifically excluded from the jurisdiction of the CFPB.1 Nor did it task the CFTC with even a fraction of the monumental undertakings in support of the highest levels of consumer protection mandated for the SEC under Title IX. Accordingly, it is up to the Commission to examine our regulations, especially those promulgated under discretionary authority to act in the public interest, and revisit our reasoning to ensure that the underlying law and policy are appropriate in light of changing and evolving markets, products, and participants. If there are any vulnerabilities to our regulatory structure, it is of our own doing, and that cannot be acceptable.

    Indeed, our action today is supported by the SEC, which is reviewing the use of derivatives by investment companies.2 As highlighted in the preamble to the Amendments to Compliance Obligations, the SEC recognizes that the increased use and complexity of derivatives by SEC registrants was not contemplated when the Investment Company Act was enacted in 1940 (the “1940 Act”), and that it is time to evaluate the current practices of investment companies and the appropriateness of the regulatory regime under the 1940 Act given the current realities of derivatives usage. In its recent concept release regarding the use of derivatives by registered investment companies, the SEC noted that although its staff had addressed issues related to derivatives on a case-by-case basis, it had not developed a “comprehensive and systematic approach to derivatives related issues.”3 As aptly noted by the Chairman of the SEC, “The controls in place to address fund management in traditional securities can lose their effectiveness when applied to derivatives.”4

    The amendments to the part 4 regulations were originally the subject of a petition by the National Futures Association (“NFA”) in August of 2010. The NFA serves as one of the Commission’s certified Self-Regulatory Organizations (“SRO”) for futures markets, and it proposed this change in registration as thousands of funds, which are not registered with the Commission, are accepting billions of dollars in investments in futures and swaps markets. These rule changes will remove a major loophole that has allowed certain funds to market and sell investments in commodity futures markets, but remain outside the jurisdiction of the Commission through, among other things, the use of IRS private letter rulings that permit registered investment companies (“RICs”) to create offshore shell corporations commonly referred to as controlled foreign corporations (“CFCs”), hold 100% of the stock in the CFC, and then use the CFC to invest in commodities. The private letter rulings permit the RIC to treat this activity as an investment in the stock of the CFC and not as an investment in commodities, and because the CFC’s sole investor is a RIC, both the RIC and CFC were excluded from registration under regulations 4.5 and 4.13(a)(4) prior to these new amendments. Until now, while the RIC was at least required to be registered with the SEC under the 1940 Act, the CFC remained completely unregistered and unregulated—in spite of the fact that these funds have been identified as having an accumulated assets in excess of $50 billion in the commodity markets.5

    With the amendment to regulation 4.5 and the rescission of regulation 4.13(a)(4), RICs which exceed the 5% de minimis threshold in new regulation 4.5(c)(2)(iii) will no longer fall under the exclusion under regulation 4.5, and CFCs which fall under the statutory definition of “commodity pool” must have their CPO register with the Commission unless they may claim exemption or exclusion therefrom on their own merits. These amendments make clear that separate, legally cognizable entities must be assessed for registration on their own characteristics. A CFC should not be entitled to an exclusion or exemption based on the fact that its parent company is a RIC entitled to exclusion under regulation 4.5.

    The NFA made a compelling case in their 2010 petition for rulemaking to revise regulation 4.5 to ensure that retail futures customers in entities currently not registered with the CFTC would be afforded the basic protections provided to all customers invested with CFTC-registered CPOs. I publicly supported that petition6 and believe the Commission has acted appropriately in enacting amendments to ensure that customers are afforded the most basic protections including the provision of fee disclosures, past performance disclosures, and account statements, and requirements for delivery and acknowledgement that a participant has received the appropriate prospectus. In addition, the rules will require consistent recordkeeping rules that will ensure standard bookkeeping standards are maintained and currently-regulated CPOs are not put at a competitive disadvantage.

    To be clear, registration with the Commission is not duplicative of registration with the SEC. Not only is the Commission in the best position to adequately oversee the derivatives trading in our jurisdictional markets, but registration ensures that all entities participating in our markets meet minimum standards of fitness and competency. Moreover, registration provides the Commission and customers a clear means of addressing wrongful conduct by entities in the derivatives markets. Our jurisdictional authority to take punitive and/or remedial action against registered entities for violations of the Commodity Exchange Act and Commission regulations is clear. This authority includes the ability to deny, limit, or revoke registration of individuals and entities who pose a threat to our markets and market participants. Moreover, customers and members of the public may only access the Commission’s reparations program and the NFA’s arbitration program to seek redress for wrongful conduct by a Commission registrant.

    Proposal on Harmonization of Compliance Obligations for Registered Investment Companies Required to Register as Commodity Pool Operators

    I believe investors must be armed with the facts when making investment decisions and MF Global customers are proof that improved transparency and disclosures are vital to making informed decisions. However, we can’t state that we are harmonizing our rules “mostly” or where it makes sense. Harmonization requires agreement and our proposed rule fails this test in some key aspects. I hope that market participants will suggest common ground on disclosure requirements that actually harmonize the documents to ensure both regulatory bodies and customers are fully informed as to the investment company’s actual fund performance returns and fee schedules without creating duplicate and confusing information. I am sensitive to the burdens of compliance, and will make a concerted effort to minimize the regulatory impact to funds, while providing customers with maximum protection.

    Consumers are facing more sophisticated, more complex, and more diverse financial markets than ever before. While the amount of available information in terms of quantity is astounding as compared to any other time, it is also deeply complex. The Commission can’t ensure all commodity customers are successful in the endeavors, nor should we, but we must offer all customers with a level playing field, no matter the investment vehicle, when investing, whether directly or indirectly, in our regulated markets.

    1 See §1027(i)-(j) of the Dodd-Frank Act.

    2 For example, the SEC recently issued a concept release seeking comment on use of derivatives by investment companies, noting: “The dramatic growth in the volume and complexity of derivatives investments over the past two decades, and funds’ increased use of derivatives, have led the [Securities and Exchange] Commission and its staff to initiate a review of funds’ use of derivatives under the Investment Company Act. (footnotes omitted)” 76 FR 55237, 55238 (Sep. 7, 2011).

    3 76 FR 55237, 55239 (Sept. 7, 2011). See, Press Release, Securities and Exchange Commission, SEC Seeks Public Comment on Use of Derivatives by Mutual Funds and Other Investment Companies (Aug. 31, 2011), available at (“‘The derivatives markets have undergone significant changes in recent years, and the Commission is taking this opportunity to seek public comment and ensure that our regulatory approach and interpretations under the Investment Company Act remain current, relevant, and consistent with investor protection,’” said SEC Chairman Mary Shapiro.”).

    4 Chairman Mary Shapiro, Opening Statement at SEC Open Meeting Item 1 – Use of Derivatives by Funds (Aug. 31, 2011), available at (“The current derivatives review gives us the opportunity to re-think our approach to regulating funds’ use of derivatives. We are engaging in this review with a holistic perspective, in the wake of the financial crisis, and in light of the new comprehensive regulatory regime for swaps being developed under the Dodd-Frank Act.”).

    5 See “Excessive Speculation and Compliance with the Dodd-Frank Act,” hearing before the U.S. Senate Permanent Subcommittee on Investigations (November 3, 2011), Exhibit 7a.

    6 See Statement by Commissioner O’Malia, Changes to Improve CFTC Oversight of Retail Commodity Funds, Sept. 1, 2010, available at

    Last Updated: February 8, 2012

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