[Federal Register: October 28, 2002 (Volume 67, Number 208)]
[Proposed Rules]
[Page 65743-65746]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr28oc02-29]

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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 4

RIN 3038-AB34


Exclusion for Certain Otherwise Regulated Persons From the
Definition of the Term "Commodity Pool Operator"

AGENCY: Commodity Futures Trading Commission.

ACTION: Proposed rule.

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SUMMARY: The Commodity Futures Trading Commission (Commission or CFTC)
is proposing to amend Rule 4.5 by adding an alternative limitation on
the non-hedge activities of eligible persons claiming relief under the
rule (Proposal). The Commission also is taking a "no-action" position
to permit the use of this alternative criterion pending final action on
an amendment to the rule. The Proposal and the "no-action" position
would not affect the ability of qualifying entities under Rule 4.5 to
engage in unlimited trading for bona fide hedging purposes.

DATES: Comments on the proposed rule change must be received by
December 12, 2002.

ADDRESSES: Comments on the proposed rule should be sent to Jean A.
Webb, Secretary, Commodity Futures Trading Commission, Three Lafayette
Centre, 1155 21st Street, NW., Washington, DC 20581. Comments may be
sent by facsimile transmission to (202) 418-5528, or by e-mail to
secretary@cftc.gov. Reference should be made to "Proposed Amendment to
Rule 4.5 for Non-Hedge Activity."

FOR FURTHER INFORMATION CONTACT: Barbara S. Gold, Associate Director,
Division of Clearing and Intermediary Oversight, or Ronald Hobson,
Industry Economist, Office of the Chief Economist, Commodity Futures
Trading Commission, 1155 21st Street, NW., Washington, DC 20581,
telephone number: (202) 418-5441 or (202) 418-5285, respectively;
facsimile number: (202) 418-5536, or (202) 418-5660, respectively; and
electronic mail: bgold@cftc.gov or rhobson@cftc.gov, respectively.

SUPPLEMENTARY INFORMATION:

I. Background

    The term "commodity pool operator" (CPO) is defined in section
1a(5) of the Commodity Exchange Act (Act),\1\ to mean:
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    \1\ 7 U.S.C. 1a(5) (2002).

    [A]ny person engaged in a business that is of the nature of an
investment trust, syndicate, or similar form of enterprise, and who,
in connection therewith, solicits, accepts, or receives from others,
funds, securities, or property, either directly or through capital
contributions, the sale of stock or other forms of securities, or
otherwise, for the purpose of trading in any commodity for future
delivery on or subject to the rules of any contract market or
derivatives transaction execution facility, except that the term
does not include such persons not within the intent of the
definition of the term as the Commission may specify by rule,
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regulation, or order. [Emphasis added.] \2\

    \2\ Both the Act and the Commission's rules issued thereunder
can be accessed through the Commission's Web site: http://www.cftc.gov/cftc/LawRegulation/index.htm#cea. Commission rules cited to herein are found
at 17 CFR chapter I (2002).
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    In connection with the adoption of the Futures Trading Act of
1982,\3\ the Senate Committee on Agriculture, Nutrition, and Forestry
(Committee) considered an amendment to the Act that would have exempted
certain persons from the CPO definition. In lieu of adopting such an
amendment to the CPO definition, the Committee directed the Commission
to issue regulations that would have the effect of providing relief
from regulation as a CPO for certain otherwise regulated persons with
respect to their operation of certain collective investment vehicles
that met certain criteria. These criteria specified, among other
things, that "the entity uses commodity futures or options thereon

[[Page 65744]]

solely for hedging purposes" and that "initial margin requirements or
premiums for * * * futures or options contracts will never be in excess
of 5 percent of the entity's assets. * * *" \4\ Pursuant to this
directive, in 1985 the Commission adopted Rule 4.5.\5\
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    \3\ Pub. L. No. 97-444, 96 Stat. 2294 et seq. (1983).
    \4\ S. Rep. No. 384, 97th Cong., 2d Sess. 79-80 (1982).
    \5\ 50 FR 15868 (Apr. 23, 1985), which contains a full
discussion of the history of the directive and the subsequent
adoption of Rule 4.5.
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    The purpose of Rule 4.5 is to make available to certain persons
(eligible persons) an exclusion from the definition of CPO with respect
to their operation of certain entities (qualifying entities) that would
otherwise be treated as commodity pools under the Act, but that are
already subject to extensive operating requirements of another federal
or state regulator. These eligible persons and their qualifying
entities include: (1) Investment companies registered as such under the
Investment Company Act of 1940; (2) state-regulated insurance companies
with respect to their operation of insurance company separate accounts;
(3) state- or federally-regulated financial depository institutions
with respect to their operation of separate units of investment; and
(4) trustees, named fiduciaries, certain designated fiduciaries, and
employers of pension plans subject to Title I of the Employee
Retirement Income Security Act of 1974 with respect to the operation of
such plans.\6\ In order to claim exclusion from the CPO definition
under Rule 4.5, an eligible person must file a Notice of Eligibility
with the National Futures Association (NFA) and the Commission.\7\ The
Notice must contain specified representations on how the person will
operate the qualifying entity. These operating criteria include
requirements to: restrict the amount of the entity's commodity interest
trading with respect to its non-hedging activity; not market the entity
as a pool or otherwise as a vehicle to trade commodity interests;
disclose the purpose of and restrictions on the entity's commodity
interest trading; and submit to special calls to demonstrate compliance
with the foregoing provisions. A supplemental Notice must be filed, as
necessary, to render the original Notice "accurate and complete." \8\
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    \6\ Rules 4.5(a) and (b).
    \7\ Rule 4.5(c).
    \8\ Rule 4.5(d).
    Over the past ten years, eligible persons have filed
approximately 15,500 initial and supplemental Notices with the NFA
and the Commission, as follows: registered investment companies
(filing on a series-by-series basis)--12,000; state-regulated
insurance companies--600; state- or federally-regulated financial
depository institutions--2,700; and pension plan trustees,
fiduciaries and employers--200. However, not all of the qualifying
entities named in these Notices may still be in operation as of this
date.
    Additionally, Rule 4.5 provides that certain pension plans are
not commodity pools. Because this exclusion is self-executing, no
notice must be filed to claim it. Accordingly, the amendment to Rule
4.5(c) that the Commission is today proposing does not apply to
these plans or their operation. See Rule 4.5(a)(4)(i)-(iv).
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    Based upon its staff's experience in administering Rule 4.5, the
Commission has made various revisions to the rule subsequent to its
initial adoption. These revisions have expanded the range of persons
eligible to claim relief under the rule \9\ and the trading strategies
that may be engaged in under the rule--i.e., that unlimited hedging but
limited non-hedging activities may be engaged in under the rule.\10\
Based upon staff's most recent experience with Rule 4.5, the Commission
again is proposing revisions to the rule and, in particular, to the
operating criteria concerning the amount of a qualifying entity's non-
hedging commodity interest trading.
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    \9\ See 58 FR 43791 (Aug. 18, 1993). The Commission also has
expanded the class of persons who are "non-pools" under Rule 4.5.
See 65 FR 24127 (Apr. 25, 2000).
    \10\ See 58 FR 6371 (Jan. 28, 1993).
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II. The Proposal

A. The Text of the Proposal

    Currently, Rule 4.5(c)(2)(i) provides that the Notice of
Eligibility must contain a representation that the eligible person must
operate the qualifying entity such that the entity:

    Will use commodity futures or commodity option contracts solely
for bona fide hedging purposes within the meaning and intent of
[Rule] 1.3(z)(1); Provided, however, That in addition, with respect
to positions in commodity futures or commodity option contracts
which do not come within the meaning and intent of [Rule] 1.3(z)(1),
a qualifying entity may represent that the aggregate initial margin
and premiums required to establish such positions will not exceed
five percent of the liquidation value of the qualifying entity's
portfolio, after taking into account unrealized profits and
unrealized losses on any such contracts it has entered into; And,
Provided further, That in the case of an option that is in-the-money
at the time of purchase, the in-the-money amount as defined in
[Rule] 190.01(x) may be excluded in computing such 5 percent.

    This limitation on non-hedge activity contained in Rule 4.5 has
come to be known as "the 5 percent test."
    Because futures margins have generally been set at levels near or
below 5 percent of contract value, the 5 percent test has permitted the
notional value of non-hedging commodity futures and option positions to
approximate the liquidation value of an entity's portfolio. Recently,
however, eligible persons and qualifying entities have expressed
concern to Commission staff over the 5 percent test, because margin
levels for certain stock index futures have come to significantly
exceed 5 percent of contract value, thereby limiting the use of such
contracts in non-hedging strategies to a much greater extent than other
types of contracts with lower margins.\11\ They also have expressed
concern that a similar constraint could arise with respect to security
futures products (SFPs), because the required margin for SFPs will be
20 percent of contract value.\12\
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    \11\ See, e.g., comments received in connection with the
Commission's Roundtable on CPO and CTA Issues, held on September 19,
2002. These comments may be accessed at http://www.cftc.gov/opa/press02/opa4700-02.htm.
    The Commission held the Roundtable as a result of its "Report
on the Study of the Commodity Exchange Act and the Commission's
Rules and Orders Governing the Conduct of Registrants Under the
Act." The Report was mandated by section 125 of the Commodity
Futures Modernization Act of 2000 (CFMA), which directed the
Commission to conduct a study of those sections of the Act and the
Commission's rules applicable to intermediaries. The Report can be
accessed through: http://www.cftc.gov/files/opa/opaintermediarystudy.pdf,
and section 125 of the CFMA can be accessed through: http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cftc.gov/files/ogc/ogchr5660.pdf.
    \12\ See CFTC Rule 41.45(b)(1) and Securities and Exchange
Commission Rule 403(b)(1), 67 FR 53146, 53174 and 53179,
respectively (Aug. 14, 2002).
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    In response to these concerns, the Commission is proposing to amend
Rule 4.5 by adding as an alternative to the 5 percent test a limitation
based on the notional value of non-hedge positions. This amendment
would reorganize paragraph (c)(2)(i) of the rule, to: (1) Redesignate
the 5 percent test as new paragraph (c)(2)(i)(A); and (2) provide an
alternative non-hedge operating criterion in new paragraph
(c)(2)(i)(B).
    As proposed, this alternative would provide that, with respect to
non-hedge commodity interest positions, a qualifying entity may
represent that the aggregate notional value of such positions does not
exceed the liquidation value of the qualifying entity's portfolio
(notional test). This alternative is based upon a proposal recently
made to the Commission's Division of Clearing and Intermediary
Oversight in connection with a request for "no-action" relief from
the 5 percent test of Rule 4.5(c)(2).\13\ For the purpose of the
notional test, "notional value" would be calculated for futures by
multiplying for each such position the size of the contract, in
contract units, by the current market price per unit and for

[[Page 65745]]

options by multiplying for each such position the size of the contract,
in contract units, by the strike price per unit.
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    \13\ See Letter of Barclays Global Investors, N.A. dated July
18, 2002, to Jane K. Thorpe, Director of the Division.
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    The following two examples show the different effects of the
existing and proposed non-hedging tests using futures contracts based
on equity, in one instance, and on debt, in the other instance. In each
example, the eligible person desires to establish the maximum number of
contracts permissible for the qualifying entity. In both examples, it
is assumed that the entity's liquidation value is $10 million, the
settlement level of the contract is as of September 25, 2002, and the
margin requirement is as of September 26, 2002.
    With respect to the S&P 500 Stock Price Index futures contract
traded on the Chicago Mercantile Exchange, the number of contracts the
person could establish would be:

5% of liquidation value = $500,000 (.05 x $10,000,000)
Initial non-hedge margin for a single S&P contract = $17,813, or almost
9% of contract value
S&P settlement level = 819.29 points
S&P contract value = $204,822.50 (819.29 x $250 per point)
5% Test = 28 contracts ($500,000/$17,813=28.07)
Notional Test = 48 contracts ($10,000,000/$204,822.50=48.8)

    Thus, for establishing positions in the S&P 500 Stock Price Index
future contract, the notional test would be less restrictive.
    With respect to the 10-Year Treasury Note contract traded on the
Chicago Board of Trade, the number of contracts that the eligible
person could establish would be:

5% of liquidation value = $500,000 (.05 x $10,000,000)
Initial non-hedge margin for a single T-Note contract = $1,755, or less
than 2% of contract value
T-Note settlement level = 114,160 points
T-Note contract value = $114,160 (114,160 x 100%)
5% Test = 284 contracts ($500,000/$1,755=284.9)
Notional Test = 87 contracts ($10,000,000/$114,160=87.6)

    Thus, for establishing positions in the 10-Year Treasury Note
contract, the 5 percent test would be less restrictive.
    The following table summarizes this information:

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                                                                        Initial      Settlement                                     No.       Contracts
                 Contract                   Liquidation       5%       margin (as  level (as of 9/  Multiplier  Contract value   Contracts     notional
                                               value                  of 9/26/02)      25/02)                                     5% test        test
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S&P.......................................         $10m     $500,000      $17,813          819.29         $250     $204,822.50           28           48
T-Note....................................          10m      500,000        1,755      114,160.00         100%      114,160.00          284           87
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    The Proposal (and the "no-action" position taken below) would not
affect the ability of eligible persons claiming relief under Rule 4.5
to use commodity interests for bona fide hedging purposes on an
unlimited basis. Rather, it would establish a second, alternative test
under which they could use commodity interests for other than bona fide
hedging purposes. Also, the Proposal (and the "no-action" position)
would not affect any other provision of Rule 4.5, including the proviso
following paragraph (c)(2) of the rule that:

the making of such representations [as are required in the Notice of
Eligibility] shall not be deemed a substitute for compliance with
any criteria applicable to commodity futures or commodity options
trading established by any regulator to which [an eligible] person
or qualifying entity is subject.

B. Request for Comment

    The Commission requests comment on the Proposal and on the
following issues:
    (1) Do the proposed changes adequately address perceived problems
with the existing requirements under Rule 4.5?
    (2) Is there some other limitation for non-hedge positions that the
Commission should adopt in lieu of, or in addition to, the existing and
proposed limitations?
    (3) Should the Commission impose any limitation for non-hedge
activity by persons claiming relief under Rule 4.5?

C. "No-Action" Position

    The Proposal would facilitate the use of the commodity interest
markets by persons and entities who, in accordance with Rule 4.5, are
"otherwise regulated" and it would potentially benefit other market
participants through increased liquidity. Accordingly, the Commission
has determined that, pending action on the Proposal, it will not
commence any enforcement action against an eligible person for failing
to register as a CPO in accordance with section 4m(1) of the Act,\14\
where the eligible person operates a qualifying entity in accordance
with the proposed revisions to Rule 4.5(c)(2).
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    \14\ 7 U.S.C. 6m(1).
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    Neither eligible persons who have claimed relief under Rule 4.5 nor
eligible persons who claim such relief in the future need to take any
additional action to operate their qualifying entities in accordance
with the notional test. Rather, making the representations currently
required by the rule in a Notice filed with the NFA and the
Commission--including the representation concerning the 5 percent
test--is all that is required.
    This position will remain in effect until such time as the
Commission takes final action on the Proposal. It is, however, subject
to the condition that upon adoption of any amendment to Rule 4.5, the
eligible person must comply in full with the terms of any amendment as
the Commission may adopt or with the existing 5 percent test of Rule
4.5. In the event the Commission adopts an alternative non-hedge
operating criterion that varies from the criterion proposed herein, it
will provide affected eligible persons and qualifying entities with
sufficient time within which to comply with the criterion as adopted.

III. Related Matters

A. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 (PRA),\15\ which imposes
certain requirements on Federal agencies (including the Commission) in
connection with their conducting or sponsoring any collection of
information as defined by the PRA, does not apply to the Proposal. The
Commission believes the proposed amendment of Rule 4.5 does not contain
information requirements which necessitate the approval of the Office
of Management and Budget, because the purpose of the amendment is to
provide an alternative representation that may be made to claim the
relief available under the rule.
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    \15\ 44 U.S.C. 3501 et seq.
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B. Regulatory Flexibility Act

    The Regulatory Flexibility Act (RFA) \16\ requires that agencies,
in promulgating rules, consider the impact

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of these rules on small entities. The definitions of small entities
that the Commission has established for this purpose do not address the
eligible persons and qualifying entities set forth in Rule 4.5 because,
by the very nature of the rule, the operations and activities of such
persons and entities generally are regulated by federal and state
authorities other than the Commission. Assuming, arguendo, that such
persons and entities would be small entities for purposes of the RFA,
the Commission believes that the Proposal would not have a significant
economic impact on them because it would relieve a greater number of
those persons (and entities) from the requirement to register as a CPO
and from the disclosure, reporting and recordkeeping requirements
applicable to registered CPOs.
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    \16\ 5 U.S.C. 601 et seq.
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    Accordingly, the Chairman, on behalf of the Commission, certifies
pursuant to section 3(a) of the RFA,\17\ that the Proposal will not
have a significant economic impact on a substantial number of small
entities. Nonetheless, the Commission invites comment from any person
who believes that these rules, as proposed, would have a significant
economic impact on its operation.
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    \17\ 5 U.S.C. 605(b).
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List of Subjects in 17 CFR Part 4

    Commodity pool operators, Commodity trading advisors, Commodity
futures, Commodity options.

    Accordingly, 17 CFR chapter I is proposed to be amended as follows:

PART 4--COMMODITY POOL OPERATORS AND COMMODITY TRADING ADVISORS

    1. The authority citation for part 4 continues to read as follows:

    Authority: 7 U.S.C. 1a, 2, 6b, 6c, 6(c), 6l, 6m, 6n, 6o, 12a,
and 23.

Subpart A--General Provisions, Definitions and Exemptions

    2. Section 4.5 is proposed to be amended by revising paragraph
(c)(2)(i) to read as follows:


Sec.  4.5  Exclusion for certain otherwise regulated persons from the
definition of the term "commodity pool operator."

* * * * *
    (c) * * *
    (2) * * *
    (i) Will use commodity futures or commodity options contracts
solely for bona fide hedging purposes within the meaning and intent of
Sec.  1.3(z)(1) of this chapter; Provided, however, That in addition,
with respect to positions in commodity futures or commodity option
contracts which do not come within the meaning and intent of Sec.
1.3(z)(1), a qualifying entity may represent that:
    (A) The aggregate initial margin and premiums required to establish
such positions will not exceed five percent of the liquidation value of
the qualifying entity's portfolio, after taking into account unrealized
profits and unrealized losses on any such contracts it has entered
into; Provided further, That in the case of an option that is in-the-
money at the time of purchase, the in-the-money amount as defined in
Sec.  190.01(x) of this chapter may be excluded in computing such five
percent; or
    (B) The aggregate notional value of such positions does not exceed
the liquidation value of the qualifying entity's portfolio, after
taking into account unrealized profits and unrealized losses on any
such contracts it has entered into. For the purpose of this paragraph
(c)(2)(i)(B), the term "notional value" shall be calculated for each
such futures position by multiplying the size of the contract, in
contract units, by the current market price per unit and for each such
option position by multiplying the size of the contract, in contract
units, by the strike price per unit;
* * * * *

    Issued in Washington, DC, on October 22, 2002, by the
Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 02-27309 Filed 10-25-02; 8:45 am]
BILLING CODE 6351-01-P