Special FX

Already know everything you need to about registration with the US Commodity Futures Trading Commission (CFTC)? If so, you’d be in the minority, according to speakers and delegates who gathered in San Francisco last week for our PE/VC Finance & Compliance Forum.

Registration with the CFTC isn’t compulsory for all fund managers, but something every firm needs to be aware of following the implementation of Dodd-Frank. In addition to their normal duties of regulating futures contracts and commodities, the CFTC now has greater supervision over the swaps marketplace and FX transactions (which a number of firms, and more so their portfolio companies, use to hedge against currency risk). 

CFTC: yet another watchdog for  GPs to consider

Ahead of the 31 December registration deadline, GPs should be busily confirming what types of over-the-counter derivatives, if any, are used by the firm, portfolio companies or any affiliates. If a private equity fund trades even one commodity interest contract or holds itself out as being able to do so, it may have to register, according to lawyers in attendance. But exactly what they would have to register as is complex. Under the rules a distinction is made between a commodity pool operator (CPO) and a commodity trading advisor (CTA). “The easiest way to think of it is the sponsor of the fund, most typically the general partner, is the CPO, and the investment manager is the CTA,” said private funds lawyer Karl Cole-Frieman of Cole-Frieman & Mallon.

Those definitions will matter significantly when determining which funds qualify for CFTC registration exemptions. Firms relying on certain de minimus exemptions, which must now be filed on an annual basis, avoid having to take and pass a Series 3 examination and CFTC reporting requirements. 

One chief compliance officer for a global firm pointed out that an entity wouldn’t necessarily need to register if it could prove that it wasn’t an actual commodity advisor. The CCO said he applies the “pork processor” test – a moniker stemming from a pig farming company that avoided CFTC registration by successfully arguing its purchase of futures was related to trading pig products, and had nothing to do with buying and selling contracts as a pure financial entity. “That became my test; are we a pork processor or not?” the delegate said. 

He says this test was kept in mind when combing through his firm’s portfolio for FX contracts being used to hedge against foreign currency risk related to the euro. With assistance from the firm’s deal teams, who helped structure the transactions, he identified exactly where in the acquisition the swap was held, and then examined whether that entity was engaged in enough other activity to be legitimately considered an operating company. If not, the entity might have had to register as a commodity pool. Did the entity “hire people or do a legitimate business?” the delegate rhetorically asked the audience. “Luckily that same entity hired due diligence consultants and a few other service providers so we got comfortable with it being unregistered.” It was in other words a pork processor, a determination that had to be made again and again across the firm’s portfolio – time consuming work that some GPs are only just realising they need to do with their own portfolios.

The hope is that most GPs will be exempt from CFTC registration, but it nonetheless represents yet another regulator whose policies private equity firms must study and understand.