Searching over 5,500,000 cases.


searching
Buy This Entire Record For $7.95

Download the entire decision to receive the complete text, official citation,
docket number, dissents and concurrences, and footnotes for this case.

Learn more about what you receive with purchase of this case.

Investment Company Institute, et al v. United States Commodity Futures Trading Commission

December 12, 2012

INVESTMENT COMPANY INSTITUTE, ET AL.,
PLAINTIFFS,
v.
UNITED STATES COMMODITY FUTURES TRADING COMMISSION,
DEFENDANT.



The opinion of the court was delivered by: Judge Beryl A. Howell

MEMORANDUM OPINION

Plaintiffs Investment Company Institute ("ICI") and Chamber of Commerce of the United States of America, two business associations, filed this lawsuit under the Administrative Procedure Act ("APA") and the Commodity Exchange Act ("CEA") challenging recent amendments to two sections, 17 C.F.R. §§ 4.5 and 4.27, of regulations promulgated by the U.S. Commodity Futures Trading Commission ("CFTC") regarding Commodity Pool Operators ("CPOs"). See Final Rule, Commodity Pool Operators and Commodity Trading Advisors: Compliance Obligations, 77 Fed. Reg. 11,252 (Feb. 24, 2012) ("Final Rule"), as corrected due to Fed. Reg. errors in its original publication, 77 Fed. Reg. 17,328 (Mar. 26, 2012). The challenged amendments rescind certain CPO registration and reporting exclusions, which have been in effect for less than a decade, in order to respond to significant legislative changes enacted in the aftermath of the financial crisis by the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) ("Dodd-Frank"). The gravamen of the plaintiffs' Complaint is that, through these amended rules, the CFTC has, without sufficient explanation, extended its regulatory reach to registered investment companies ("RICs")*fn1 that engage in derivatives trading.

Notably, the plaintiffs do not dispute that the CFTC has the authority to regulate derivatives trading by RICs or that the CFTC has broad discretionary power to set eligibility criteria for entities covered by the statutory definition of CPO, which triggers registration and concomitant reporting and disclosure requirements. Rather, the plaintiffs challenge the sufficiency of the rule-making process underlying these challenged amendments. Specifically, amended Section 4.5 reinstates, with some modifications, a pre-2003 trading threshold and marketing restriction for advisers to mutual funds and RICs claiming an exclusion from the definition of CPO, and thereby from CFTC regulation. See 77 Fed. Reg. at 11,253--54. The new section 4.27 "imposes[s] new quarterly reporting obligations on commodity pool operators," including the advisers to mutual funds and RICs that now qualify as CPOs. Compl., ECF No. 1, ¶ 1 (citing 77 Fed. Reg. at 11,285).

In their six-count Complaint, the plaintiffs offer two legal bases for their challenges to Sections 4.5 and 4.27 of the Final Rule, arguing that, in promulgating the amendments, the CFTC, first, proceeded in an arbitrary and capricious manner in violation of the APA, and, second, failed to comply with the analysis required under Section 15(a) of the CEA. As a result, the plaintiffs seek vacatur of Section 4.5 in its entirety and of Section 4.27 as applied to RICs.*fn2

Pending before the Court is Plaintiffs' Motion for Summary Judgment, ECF No. 8, and Defendant Commodity Futures Trading Commission's Cross-Motion for Summary Judgment, and Motion to Dismiss in Part, ECF No. 15. After hearing argument on these motions, and for the reasons explained below, the Court will deny Plaintiffs' Motion for Summary Judgment, grant the CFTC's Motion to Dismiss in Part, and grant the CFTC's Cross-Motion for Summary Judgment.

I.FACTUAL AND LEGAL BACKGROUND

A.The Regulation of Registered Investment Companies

There is no dispute that RICs are heavily-regulated. Indeed, the plaintiffs assert that investment companies are "among the most highly regulated entities in the financial industry" and are subject to all four major federal securities laws: the Investment Company Act of 1940 ("ICA"), the Investment Advisors Act of 1940, the Securities Act of 1933, and the Securities Exchange Act of 1934. Compl. ¶¶ 2, 12 ; see also id.¶ 12 (noting that "'[a] mutual fund is one of the most regulated types of companies in the United States'" (quoting Clifford E. Kirsch and Bibb L. Stench, 1 MUTUAL FUNDS AND EXCHANGE TRADED FUNDS REGULATION, § 1:4.1 (3d ed. 2011))); id. ¶ 13 (noting that the ICA "'imposes an extensive federal regulatory structure on investment companies'" (quoting Thomas P. Lemke, et al., 1 REGULATION OF INVESTMENT COMPANIES § 1.01 at 1-2 (2011)). Underlying the plaintiffs' claims is their view that the CFTC must demonstrate why this extant regulation is not sufficient before imposing more regulation on RICs. See id. ¶ 3 ("In adopting the rule in issue here the Commission . . . nowhere explained or determined in any manner that SEC regulation was proving to be insufficient . . . ."); Pls.' Mem. at 1 (noting that, the CFTC, in promulgating the Final Rule, "pointed to no protections resulting from its new Rule that were not already supplied by the SEC").

Investment companies are subject to some CFTC regulations that "apply broadly to market participants regardless of registration status," Pls.' Mem. in Supp. of Mot. for Summ. J. ("Pls.' Mem."), ECF No. 8, at 6 (citing 17 C.F.R. Parts 15-21), and, for most of the history of the CEA, have been required to register with the CFTC when engaging in financial activities that qualify as a commodity pool, unless they met certain eligibility restrictions for an exclusion. The term "commodity pool operator" ("CPO") is broadly defined to include "'any' person or entity operating a business in which they solicit or accept value 'for the purpose of trading in commodity interests, including any' commodity future, option, swap, or certain other specified types of instruments." Def.'s Mem. in Supp. of Cross-Mot. for Summ. J., Opp'n to Pls.' Mot. for Summ. J., and Mot. to Dismiss in Part ("Def.'s Mem"), ECF No. 15, at 5 (quoting 7 U.S.C. § 1a(11)(A)). For a period of less than a decade since 2003, RICs have been "effectively exclude[d]" altogether from the definition of CPO, and consequently from CFTC registration of CPOs. See Compl. ¶¶ 18--21; Pls.' Mem. at 16--18. Thus, the CFTC's regulation of these entities pursuant to the Final Rule is not an entirely new regulatory scheme for RICs.

The plaintiffs here argue that registration by RICs with the CFTC is unnecessary because these entities are already regulated by the SEC. The CFTC explains, however, that, given its congressional mandate to administer the CEA "to foster open, competitive, and financially sound commodity and derivatives markets," 77 Fed. Reg. at 11,278, the Final Rule regulates RICs in their capacity as CPOs operating in derivatives markets and with respect to CFTC-regulated products, rather than targeting RICs operating in SEC-regulated markets. Thus, the CFTC's view is that the regulation of RICs operating as CPOs, after a brief period of deregulation, is not duplicative of the SEC's regulation of investment companies. Id. at 11,262 ("The Commission does not believe it is accurate to state that Congress intended to avoid oversight by both agencies, and indeed Congress clearly anticipated some overlap . . . . Therefore, the Commission concludes that dual registration of certain entities is not irreconcilable with the Congressional intent underlying the Dodd-Frank Act.").

1.CFTC's Regulation of Registered Investment Companies from 1974 to 2003

A brief review of the history of the regulation of RICs by the CFTC is helpful in understanding the context of the plaintiffs' challenges to the Final Rule. The CFTC was established in 1974 by the Commodity Futures Trading Commission Act, Pub. L. No. 93-463, 88 Stat. 1389. Pursuant to the CEA, the CFTC is the exclusive federal regulator of many derivative instruments and markets. See 7 U.S.C. § 2(a)(1).*fn3

The CEA provides that all CPOs must register with the CFTC and file such reports as the CFTC may prescribe. 7 U.S.C. § 6k. Since the CEA "sets no minimum trading threshold for qualification as a CPO, . . . . a pooled investment vehicle operator is a statutory CPO if it trades even a single commodity, option or swap." Def.'s Mem. at 6 (citing 7 U.S.C. § 1a(11)(A)).*fn4

Unless subject to an exemption or exclusion, all CPOs must register with the CFTC, see 7 U.S.C. § 6k, and are subject to regulatory requirements related to disclosure to investors, see 17 C.F.R. §§ 4.21-- 4.22, 4.24--4.25, recordkeeping, id. § 4.23, segregation of investor assets, id. § 4.20, and registration and reporting obligations, see 7 U.S.C. §§ 6k, 6n. See Pls.' Mem. at 7. CPOs must also become members of the National Futures Association ("NFA"), the self-regulatory organization for the commodities industry. Id.*fn5

Under the CEA, the CFTC has statutory authority to exclude entities from the definition of "CPO," thereby relieving such exempted entities from the CFTC's registration requirements and attendant obligations. See 7 U.S.C. § 1a(11)(B) ("The Commission, by rule or regulation, may include within, or exclude from, the term 'commodity pool operator' any person engaged in a business that is of the nature of a commodity pool, investment trust, syndicate, or similar form of enterprise if the Commission determines that the rule or regulation will effectuate the purposes of this chapter."). The CFTC "has exercised this authority over the years to expand and contract exclusions in response to new information and changing circumstances." Def.'s Mem at 6.

During the CFTC's early years, when entities raised questions concerning their coverage as a CPO, the CFTC would evaluate their operations on a case-by-case basis and issue "not a pool" letters affording relief from the CPO regulations when the entity met certain conditions, including that the entity:

(1) was subject to extensive Federal or State regulation; (2) would be using commodity interests for hedging purposes; (3) would commit only a small percentage of its assets - e.g., 5% - to its commodity interest trading; (4) would not be promoted as a commodity pool; and (5) would disclose, as appropriate, the purpose of and limitations on its commodity interest trading.

49 Fed. Reg. 4778 (Feb. 8, 1984); see also Def.'s Mem. at 6 ("Entities receiving individual exclusions typically used commodities for hedging risks rather than speculation; would commit only a small percentage of assets to commodity trading; would not be promoted as a commodity pool investment; would disclose to investors the purpose and limitations of their commodity trading; and were subject to extensive federal or state regulation." (citing CPO & CTA: Exemption from Registration, 49 Fed. Reg. 4778, 4779 (Notice of Proposed Rulemaking Feb. 8, 1984))).

The CFTC brought this practice to the attention of Congress when, in 1982, the Senate Committee on Agriculture, Nutrition, and Forestry considered and rejected as "too broad" a proposed amendment that would have exempted from the CPO definition, inter alia, "any person regulated under the [ICA] . . . which utilizes less than 10 percent of its pooled assets. . . . for futures trading and which was not established to conduct business as a commodity pool." 49 Fed. Reg. at 4779 (citing S. Rep. No. 97-384, at 79--80 (1982)). Instead, the Committee directed the CFTC to issue regulations "which would have the effect of exempting certain otherwise regulated persons from registration as a CPO," only if certain conditions were met, namely, that:

(1) the entity uses commodity futures contracts of [sic] options thereon solely for hedging purposes; (2) initial margin requirements or premiums for such futures or options contracts will never be in excess of 5 percent of the fair market value of the entity's assets (in the case of an investment company) or of the assets of any trust, custodial account or other separate unit of investment for which the entity is acting as a fiduciary; (3) the entity has not been and will not be, marketing participations to the public as or in a commodity pool or otherwise as or in a vehicle for trading in the commodities markets; and (4) the entity will disclose to each prospective participant the purpose of and limitations on the scope of the commodity futures or commodity option trading it conducts for such participants. Id.

Prompted by this congressional directive, in 1985, the CFTC added Section 4.5, which provided an exclusion of "certain otherwise regulated persons from the definition of the term 'commodity pool operator.'" CPOs; Exclusion for Certain Otherwise Regulated Persons, 50 Fed. Reg. 15,868 (Apr. 23, 1985). Under this new provision, persons, including RICs, seeking to claim the exclusion were required to file with the CFTC a "notice of eligibility," including basic identifying information as well as a series of representations. Id. at 15,875. Specifically, the notice of eligibility had to represent that the qualifying entity: first, "[w]ill use commodity futures or commodity options contracts solely for bona fide hedging purposes within the meaning and intent of § 1.3(z)(1)," unless subject to an alternative representation applicable in certain circumstances; second, "[w]ill not enter into commodity futures and commodity options contracts for which the aggregate initial margin and premiums exceed 5 percent of the fair market value of the entity's assets, after taking into account unrealized profits and unrealized losses on any such contracts it has entered into;" third, "[w]ill not be, and has not been, marketing participations to the public as or in a commodity pool or otherwise as or in a vehicle for trading in the commodity futures or commodity options markets;" fourth, "[w]ill disclose in writing to each prospective participant the purpose of and the limitations on the scope of the commodity futures and commodity options trading in which the entity intends to engage;" and, finally, "[w]ill submit to such special calls as the Commission may make to require the qualifying entity to demonstrate compliance with the provisions of this § 4.5(c)." Id. at 15,883. These provisions, including the 5% trading threshold, the marketing restriction, and the bona fide hedging requirement, were, as the defendant notes, "precursors to the criteria contained in the Final Rule at issue in this case." Def.'s Mem. at 7.

The plaintiffs suggest that "[i]nvestment companies responded to these requirements by generally restricting their investment in commodity interests to meet these conditions, so that they would not be subject to the overlapping regulatory jurisdiction of both the SEC and the CFTC." Pls.' Mem. at 8 (citing David E. Riggs & Charles C.S. Park, Mutual Funds: A Banker's Primer, 112 BANKING L.J. 757, 760-61 (1995) ("While mutual funds can, and do, invest in commodity futures contracts, their investments in such contracts are limited so as to avoid classification and regulation as [CPOs]")).

Section 4.5 remained essentially the same until 2003, when, as discussed in more detail below, prompted by further legislative action, the CFTC modified the coverage of the CPO definition. Thus, for nearly thirty years, from 1974, when the CFTC was established, until 2003, RICs were included in the commodity pool operator ("CPO") definition in 17 C.F.R. § 4.5, and thus subject to regulation by the CFTC when they engaged in the trading of commodity interests, unless subject to exclusion as a qualifying entity after 1985. See 7 U.S.C. § 6m(1).

2.The Rise of "Swaps" in the Financial Industry and the Deregulation of Commodity Markets in the Early 2000s

During the 1980s and 1990s, "swaps," a kind of derivative contract, became "pervasive." Def.'s Mem. at 7. Swaps "are financial contracts in which two counterparties agree to exchange or 'swap' payments with each other as a result of such things as changes in a stock price, interest rate or commodity price." SEC, THE REGULATORY REGIME FOR SECURITY-BASED SWAPS 3 (2012), available at http://www.sec.gov/swaps-chart/swaps-chart.pdf; see also Norman Menachem Feder, Deconstructing Over-the-Counter Derivatives, 2002 Colum. Bus. L. Rev. 677, 701-16.

The increasing use of swaps prompted a debate about whether swaps should be regulated like other derivatives. In 2000, the defendant notes, "[p]roponents of deregulation prevailed," Def.'s Mem. at 9, with Congress passing the Commodity Futures Modernization Act ("CFMA"), Pub. L. No. 106-554, 114 Stat. 2763 (2000). The CFMA barred the CFTC and SEC from regulating most swaps, including over-the-counter ("OTC") swaps markets. See 7 U.S.C. § 2(g) (2002); CFMA §§ 302-303, 114 Stat. at 2763A-452 (prohibiting SEC from regulating certain swaps and swap-based agreements). Congress intended the CFMA "to streamline and eliminate unnecessary regulation," to "enhance the competitive position of United States financial institutions and financial markets," and to "reduce systemic risk." CFMA § 2, 124 Stat. at 2763A-366. As the defendant indicates, this "left the markets for swaps and other OTC derivatives essentially unregulated and unmonitored - effectively dark - in most respects." Def.'s Mem. at 9--10.

In 2003, in response to the CFMA, the CFTC, diverging from its policies of the preceding thirty years, amended a number of rules, including the trading threshold and marketing restriction required in Section 4.5 for CPOs, in order to be "'consistent with the purpose and intent of the CFMA.'" Def.'s Mem. at 10 (quoting 2003 Rule, 68 Fed. Reg. at 47,222). Specifically, these amendments "eliminated the 5 percent ceiling for derivatives trading by RICs without CFTC registration, along with any requirement that an excluded entity trade commodities only for hedging purposes." Id. The 2003 Rule Release explained the purpose of eliminating the trading threshold and marketing restriction to, inter alia, "encourage and facilitate participation in the commodity markets by additional collective investment vehicles and their advisers, with the added benefit to all market participants of increased liquidity" and "increase the available range of risk management alternatives." Additional Registration and Other Regulatory Relief for CPOs and Commodity Trading Advisors ("2003 Rule"), 68 Fed. Reg. 47,221, 47,230 (Aug. 8, 2003) (to be codified at 7 C.F.R. pt. 4).

The 2003 amendments effectively excluded RICs from the CPO definition, relieving RICs of "most CFTC oversight." Def.'s Mem. at 1; Compl. ¶¶ 2, 21. See generally 2003 Rule. This deregulation meant that "RICs could engage in unlimited derivatives trading, for any purpose, without CFTC registration, including unlimited trading in swaps." Def.'s Mem. at 10. The defendant notes that swaps were not explicitly discussed in the promulgation of the 2003 amendment because the CFMA "placed those markets outside of the CFTC's jurisdiction."

Def.'s Mem. at 10. As a result of the deregulation effected by the CFMA, "[m]any entities invested heavily in commodity derivatives, including swaps, with limited regulatory oversight." Id. (citing Final Rule, 77 Fed. Reg. at 11,255 n.35).

B.The Financial Crisis and Dodd-Frank Wall Street Reform and Consumer Protection Act

Within five years of the 2003 amendments to Section 4.5, the financial crisis of 2007-2008 surfaced and began an "unraveling of this country's financial sector," which led to a "crisis that nearly crippled the U.S. economy beginning in 2008." S. Rep. No. 111-176 at 2, 29 (2010).*fn6

This financial crisis dramatically altered the landscape of financial regulation in the United States. The defendant argues that the financial crisis was "widely . . . attributed in significant part to the unchecked growth in the 2000s of dark, unregulated markets in over-the-counter derivatives including swaps." Def.'s Mem. at 11 (citing S. Rep. No. 111-176, at 29); see also S. Rep. No. 111-176, at 29 ("By the time of the 2008 crisis, the derivatives market had grown to be almost fifty times as large . . . . Much of this growth has been attributed to the Commodities Futures Modernization Act of 2000 . . . ."); 156 Cong. Rec. S3605 (May 12, 2010) (Statement of Sen. Shelby) ("[T]here is no debate that the lack of transparency in the OTC derivatives market was a contributing factor to the financial debacle."); Final Report of the Nat'l Comm'n on the Causes of the Fin. and Econ. Crisis in the U.S. ("Financial Crisis Report") at xxv (Jan. 2011) ("[T]he existence of millions of derivatives contracts of all types between systematically important financial institutions - unseen and unknown in this unregulated market - added to uncertainty and escalated panic . . . .")).*fn7

In 2010, Congress responded to the "upheaval in the financial sector" by passing Dodd-Frank. Def.'s Mem. at 1--2. Dodd-Frank expanded the CFTC's jurisdiction over commodities trading by giving the CFTC "primary jurisdiction over most swaps." Def.'s Mem. at 11 (citing Dodd-Frank, title VII, 124 Stat. at 1641-1802; id. § 722(a); 7 U.S.C. § 2(a)(1)(A); id. § 1a(47)). Significantly for purposes of this case, it also repealed key provisions of the CFMA, on which the CFTC's 2003 regulatory actions were based. See 68 Fed. Reg. at 47,223 (noting that the 2003 rule was "consistent with the purpose and intent of the CFMA (Commodity Futures Modernization Act of 2000)"). Among the repealed CFMA provisions were those "that exclud[ed] or exempt[ed], in whole or in part, certain [commodities] transactions from [CFTC] oversight under the CEA." See Effective Date for Swap Regulation, 76 Fed. Reg. 35,372, 35, 375 (detailing seven provisions excluding or exempting transactions from CFTC oversight, which, under Dodd-Frank, were removed from the CEA as of July 16, 2011); see also Dodd-Frank, Pub. L. No. 111-203, §§ 723, 734, 124 Stat. 1675, 1718 (2010) (repealing subsections (d),

(e), (g), and (h) of Section 2 of the CEA and Sections 5a and 5d of the CEA).*fn8 In removing the exemptions and exclusions that were added in the 2000 CFMA to shield commodities transactions from CFTC oversight, Dodd-Frank effectively unraveled the legislation that had formed the basis for the CFTC's 2003 Rule.

The changed outlook of legislators and financial regulators following the financial crisis regarding regulation of the financial markets generally and derivatives trading, including swaps, specifically, is well documented. The Congressional Research Service ("CRS") noted in 2010 that "[p]rior to the financial crisis that began in 2007, over-the-counter (OTC) derivatives were generally regarded as a beneficial financial innovation that distributed financial risk more efficiently and made the financial system more stable, resilient, and resistant to shocks." MARK

JICKLING & KATHLEEN ANN RUANE, CONG. RESEARCH SERV., THE DODD-FRANK WALL STREET REFORM AND CONSUMER PROTECTION ACT: TITLE VII, DERIVATIVES ("JICKLING & RUANE, DERIVATIVES") 1 (2010). "The [financial] crisis essentially reversed this view." Id. Dodd-Frank thus "attempt[ed] to address the aspect of the OTC market that appeared most troublesome in the crisis: the market permitted enormous exposure to risk to grow out of the sight of regulators and other traders." Id. In contrast to the context of deregulation in which the 2003 Rule had been promulgated, Congress, in Dodd-Frank, "charg[ed] the CFTC with the task of illuminating previously dark markets in the complex derivative instruments at the heart of the crisis known as 'swaps.'" Def.'s Mem. at 2; see also Mary L. Schapiro, Chairman, SEC, Opening Statement at the SEC Open Meeting (Oct. 17, 2012) ("SEC Chairman Statement"), available at http://www.sec.gov/news/speech/2012/spch101712mls.htm (noting that SEC's rules proposed under Dodd-Frank "intended to make the financial system safer, and the derivative markets fairer, more efficient, and more transparent").

To further the congressional purposes, as outlined in the Dodd-Frank Conference Report, see H.R. Rep. No. 111-517 (2010) (Conf. Rep.) ("Conference Report"), Title VII of Dodd-Frank "amended the statutory definition of the terms 'commodity pool operator' and 'commodity pool' to include those entities that trade swaps." Final Rule, 77 Fed. Reg. at 11,258 & n.71 (citing 7 U.S.C. §§ 1a(10), 1a(11)). Specifically, with respect to Title VII, the Conference Report "establishe[d] a new regulatory framework to cover a broad range of participants and institutions in the over-the-counter derivatives market," and stated, in relevant part: (1) that the CFTC was "authorized to write rules for the swaps . . . market[];" and that the CFTC and SEC (2) "shall consult and coordinate on rules and include the prudential regulators, to the extent possible, to assure regulatory consistency and comparability;" and (3) "will register participants in the market including dealers, major participants, clearing agencies and organizations, exchanges, swap execution facilities, and trade repositories." Conference Report at 868-69. Furthermore, the Conference Report explained that "[e]xemptions and exclusions from registration will apply as outlined in the report or at the discretion of the regulators." Id. at 869.*fn9

Dodd-Frank also established the Financial Stability Oversight Council ("FSOC"), "a new framework" intended "to prevent a recurrence or mitigate the impact of financial crises that could cripple financial markets and damage the economy." S. Rep. No. 111-176, at 2 (2010). FSOC is "composed of the leaders of various state and federal financial regulators and is[, inter alia,] charged with identifying risks to the financial stability of the United States." Final Rule, 77 Fed. Reg. at 11,252. The CFTC is "among those agencies that could be asked to provide information necessary for the FSOC to perform its statutorily mandated duties." Id.

While the 2003 regulations remained in effect following Dodd-Frank, and although the CFTC retained its authority to exclude entities from the CPO definition, the defendant argues that, "[t]he premises underlying the 2003 amendment were vitiated." Defs.' Mem. at 25. Indeed, the plaintiffs recognized the significance of Dodd-Frank and the need, in response, for regulatory overhaul of the derivatives market. See Letter from David T. Hischmann, President and CEO, Ctr. for Capital Mkts. Competitiveness of the U.S. Chamber of Commerce to David Stawick, Secretary, CFTC (Apr. 12, 2011) ("Chamber of Commerce Letter"), Admin. Record ("AR")*fn10 at 706, ECF No. 30-7 (stating that in July 2011, the effective date of the Dodd-Frank amendments, "the definition of a CPO will be expanded to cover both futures and swaps (i.e., both exchange-traded and over-the-counter ('OTC') derivatives[)]. This expansion represents a major change to the regulation of derivatives that, in turn, necessitates a complete overhaul of the administrative rules that apply to the derivatives markets.").

C.The Challenged Rulemaking Process

1.NFA Petition to Restore Section 4.5 to Be Substantially Similar to Rule in Effect Before 2003 Deregulation Due to Concerns About Mutual Funds Circumventing Federal Regulation Following the passage of Dodd-Frank, the NFA filed a petition of rulemaking with the CFTC requesting that, in light of developments in the commodities futures market, the CFTC amend Section 4.5 "to restore operating restrictions on registered investment companies that are substantially similar to those in effect prior to 2003." AR at 199, ECF No. 30-3 (NFA Petition for Rulemaking to Amend CFTC Regulation 4.5, dated Aug. 18, 2010); AR at 1-2, ECF No. 30-1 (Notice of NFA Petition and Request for Comment, dated Sept. 17, 2010). Specifically, the NFA, which has the mission of helping "ensure the protection of consumers participating in the commodity futures market," informed the CFTC that it was aware of "at least three entities filing for exclusions" under Section 4.5 for RICs that were using subsidiaries to market futures investments to retail customers. AR at 201. These entities were "structured differently than public commodity pools" subject to CFTC regulation, but the aim of these funds was thesame, namely "targeting retail investors with in some cases minimum investment amounts of as little as $1,000 who want exposure to actively managed futures strategies." Id. at 202.

The NFA noted, however, that "while these funds' offering materials indicate that the subsidiaries are subject to certain investment restrictions applicable to the funds themselves, these subsidiaries are neither commodity pools regulated by the CFTC and NFA nor registered investment companies." Id. at 206. The NFA further noted that "the prospectuses make clear that the subsidiaries are not subject to the Investment Company Act of 1940's customer protection regime." Id. at 206-207. This means that the "subsidiaries' daily operations, including their actual derivatives positions (including the positions' leverage amounts) and fees charged are not entirely transparent." Id. at 207. The NFA further explained that, in practice, mutual funds are investing "up to 25% of [their] total assets in [a] subsidiary, and by leveraging assets at a 4 to 1 ratio, [the mutual funds are] able to achieve a managed futures exposure equal to the full net value of the fund." Id. at 202. In reviewing the prospectuses of these mutual funds, the NFA found that the prospectuses "omit[ted] substantial disclosures that would otherwise be mandated by" CFTC regulations ("Part 4" regulations), if these entities were required to register with the CFTC and subject to its regulations. Id. at 206.*fn11

The NFA expressed concern over this practice and advocated for regulation of the RICs essentially as it existed before 2003, with a requirement that persons marketing commodity funds to the public, and whose funds engage in more than a de minimis amount of futures trading or investment, be registered as CPOs and thereby "subject to the appropriate regulatory requirements and oversight by regulatory bodies with primary expertise in commodity futures." Id. at 202. In light of these developments, the NFA suggested that key premises underlying the 2003 amendments to Section 4.5 - namely that entities qualifying for exception from CFTC regulation were "otherwise regulated" - may no longer be valid. Id. at 208. As noted, "despite the fact that these [RICs referenced above] are marketed to retail customers as an actively managed futures fund, they are not subject to customer protection rules entirely comparable to the CFTC's Part 4 Regulations and NFA's Compliance Rules." Id. The NFA expressed concern that even more CPOs would "avail themselves of this alternative registered investment company structure," thereby circumventing regulation. Id.*fn12

Accordingly, the NFA requested that the CFTC amend Section 4.5 to require that a person claiming exclusion from the CPO definition, and thus from CFTC regulation, represent in its notice of eligibility: first, that its RIC will not be marketing futures participations to the public as a commodity pool or otherwise as a vehicle for trading in the commodity futures or commodity options markets, and, second, that it will use commodity futures or commodity options contracts only for bona fide hedging purposes. Id. at 209. With respect to positions held for non-bona fide hedging purposes, the NFA proposed that a person seeking an exclusion must 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." Id. The NFA recognized that, if the CFTC were to adopt these amendments, Section 4.5 "will impose the same operating restrictions on [RICs] that were in place prior to 2003," and the NFA thus suggested that the CFTC provide time for RICs to comply with these reinstated regulations. Id.

2.Notice of Proposed Rulemaking and Notice and Comment Period

Following receipt of the NFA Petition, and in light of the financial crisis and the passage of Dodd-Frank, on February 11, 2011, the CFTC issued a Notice of Proposed Rulemaking, proposing to amend Section 4.5 to narrow the definitional exclusion for RICs and to rescind or modify other exemptions and exclusions. See Notice of Proposed Rulemaking, Commodity Pool Operators and Commodity Trading Advisors: Amendments to Compliance Obligations, 76 Fed. Reg. 7976 (Feb. 11, 2011) ("2011 NPRM"). The Notice of Proposed Rulemaking emphasized that "[f]ollowing the recent economic turmoil, and consistent with the tenor of the provisions of the Dodd-Frank Act, the [CFTC] has reconsidered the level of regulation that it believes is appropriate with respect to entities participating in the commodity futures and derivatives markets" and "believes that it is necessary to rescind or modify several of its exemptions and exclusions to more effectively oversee its market participants and manage the risks that such participants pose to the markets." Id. at 7977.

In light of this changed environment, the CFTC stated that its proposed amendments to existing regulations were intended to achieve four primary objectives: first, "bring the Commission's CPO and CTA [Commodity Trading Advisors] regulatory structure into alignment with the stated purposes of the Dodd-Frank Act;" second, "encourage more congruent and consistent regulation of similarly-situated entities among Federal financial regulatory agencies;" third, "improve accountability and increase transparency of the activities of CPOs, CTAs, and the commodity pools that they operate or advise;" and, fourth, "facilitate a collection of data that will assist the FSOC, acting within the scope of its jurisdiction, in the event that the FSOC requests and the Commission provides such data." Id. at 7978. The CFTC noted that the "added benefit" of the amendments would be that the CFTC would be able to "more efficiently deploy its regulatory resources and to more expeditiously take necessary action to ensure the stability of the commodities and derivatives markets, thereby promoting the stability of the financial markets as a whole." Id.*fn13

Accordingly, the CFTC proposed amendments, in relevant part, to "revise the requirements for determining which persons should be required to register as a CPO under § 4.5" and "require the filing of certified annual reports by all registered CPOs." Id. With respect to Section 4.5, the CFTC proposed "to reinstate the pre-2003 operating criteria consistent with the language proposed by NFA in its petition." Id. at 7984; see also id. at 7983. The CFTC noted that

Prior to amendments that the Commission made in 2003, § 4.5 required entities to file a notice of eligibility that contained a representation that the use of commodity futures for non bona fide hedging purposes will be limited to five percent of the liquidation value of the qualifying entity's portfolio and that the entity will not market the fund as a commodity pool to the public.

Id. The CFTC explained that when it adopted the 2003 amendments, its decision was "driven by comments claiming that the 'otherwise regulated' nature of the qualifying entities . . . would provide adequate customer protection." Id. at 7983 (internal quotation marks omitted) (quoting 68 Fed. Reg. 47,221, 47,223 (Aug. 8, 2003)).

In 2010, however, the CFTC "became aware of certain registered investment companies Under the approach proposed in the 2011 NPRM, a person seeking an exclusion under Section 4.5 would have to represent that its RIC "[w]ill use commodity futures or commodity options contracts, or swaps solely for bona fide hedging purposes,"*fn14 and any such portions held for non-bona fide hedging purposes would "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." Id. at 7989 (quoting 75 Fed. Reg. 56,997, 56,998 (Sept. 17, 2010)). Furthermore, the 2011 NPRM also included a marketing restriction, wherein a person seeking an exclusion under Section 4.5 must represent that the RIC "[w]ill not be, and has not been, marketing participations to the public as or in a commodity pool or otherwise as or in a vehicle for trading in (or otherwise seeking investment exposure to) the commodity futures or commodity options markets." Id. (quoting 75 Fed. Reg. 56,997, 56,998 (Sept. 17, 2010)).*fn15

The CFTC believed that this approach "would limit the possibility of entities engaging in regulatory arbitrage whereby operators of otherwise regulated entities that have significant holdings in commodity interests would avoid registration and compliance obligations under the Commission's regulations," and that, furthermore, this approach would be "appropriate to ensure consistent treatment of operators of commodity pools regardless of registration status with other regulators." Id. at 7,984. This approach would also mean that "entities that operate funds that are de facto commodity pools" would have to report their activities on Form CPO-PQR, as required by Section 4.27, discussed below. Id.

The 2011 NPRM further addressed the need for transparency in the financial markets that had been a congressional goal in the Dodd-Frank Act. Specifically, the CFTC noted that "[f]ollowing the recent economic turmoil, and consistent with the tenor of the provisions of the Dodd-Frank Act," the CFTC decided that the reporting requirements currently in place "do not provide sufficient information regarding [the] activities [of CPOs and CTAs] for the Commission to effectively monitor the risks posed by those participants to the commodity futures and derivatives markets." Id. at 7978. Thus, the CFTC proposed a new Section 4.27, which would require any CPO or CTA that is "registered or required to be registered" to "complete and submit Forms CPO-PQR or CTA-PR, respectively, with [the] NFA as the Commission's delegatee" or official custodian of the records. Id. The CFTC explained in the proposed rulemaking that it proposed these forms in order to collect information from CPOs and CTAs.*fn16 These forms, which were developed "in consultation with other financial regulators tasked with overseeing the financial integrity of the economy," would, inter alia, enable the CFTC to identify whether any commodity pools "warrant additional examination or scrutiny." Id.*fn17

The proposed rulemaking outlined numerous questions for comment, in response to which the CFTC received more than 60 comments during the public comment period. See Def.'s Mem. at 13; AR at 211-874; see, e.g., AR at 863, 865-66, ECF No. 30-9 (Comment from U.S. Senate (Dianne Feinstein, Carl Levin) (Nov. 30, 2011)) (noting that "[i]t is critical that the CFTC reinstate the [pre-2003] Section 4.5 limitations . . . so that the CFTC may properly safeguard investors and regulate the burgeoning growth of commodity related mutual funds" and that "[u]ntil the proposed amendments are adopted and effective CFTC oversight is in place, investors will continue to be vulnerable to commodity related mutual funds that operate with inadequate federal oversight"). The CFTC also held a "Roundtable" on the proposed rulemaking, in which the plaintiffs participated. See AR at 1144--1403 (Transcript of Roundtable (July 6, 2011)); id. at 1404--08 (Website Notice of Roundtable and Agenda). According to the CFTC, during an administrative process that lasted over a year, it "reviewed and considered all comments, met with interested parties, and considered all available evidence" before voting to approve the Final Rule. Def.'s Mem. at 13.

3.The Final Rule

Following the extensive notice-and-comment period, in February 2012, the CFTC voted four to one to amend Sections 4.5 and 4.27 in the Final Rule.*fn18 See CPOs & CTAs: Compliance Obligations, 77 Fed. Reg. 11,252 (Feb. 24, 2012), as corrected due to Fed. Reg. errors in its original publication, 77 Fed. Reg. 17,328 (Mar. 26, 2012). Specifically, the CFTC amended the definitional exclusion in 17 C.F.R. § 4.5 to require RICs to register with the CFTC as CPOs if the RIC engages in non-hedging commodity trading exceeding certain thresholds, or if it makes statements that the CFTC regards as marketing a product as a vehicle for trading in the commodity market. See 77 Fed. Reg. at 11,283. It also added Section 4.27, 17 C.F.R. § 4.27, to require additional reporting by all registered CPOs. See 77 Fed. Reg. at 11,285--86; id. at 11,287 (Appendix A to Part 4 (Form CPO-PQR)).

The Final Rule acknowledged the over-arching congressional purposes in the Dodd-Frank Act following the financial crisis of 2007 and 2008, "to reduce risk, increase transparency, and promote market integrity within the financial system by, inter alia, enhancing the [CFTC's] rulemaking and enforcement authorities with respect to all registered entities and intermediaries subject to the Commission's oversight." Id. at 11,252. The CFTC noted that "[f]ollowing the recent economic turmoil, and consistent with the tenor of the provisions of the Dodd-Frank Act, the Commission reconsidered the level of regulation that it believes is appropriate with respect to entities participating in the commodity futures and derivatives markets." Id.

Accordingly, the Final Rule implemented the changes it had proposed to Section 4.5 by rescinding the 2003 exclusion from registration as a CPO for RICs that would otherwise qualify, and modifying the criteria to be eligible for exclusion from the CPO definition to limit such eligibility to those collective investment vehicles that engage in a "de minimis amount of derivatives trading." Id. at 11,255. To be eligible for exclusion from the CPO definition, under amended Section 4.5, a RIC's trading in commodity futures, commodity options, or swaps may not exceed one of two trading thresholds and must comply with a marketing restriction. With respect to the trading thresholds, a RIC may be eligible for an exclusion if its non-bona fide hedging trading in commodity futures, commodity options, or swaps does not exceed two thresholds: (1) five percent or less of the liquidation value of the entity is used for aggregate initial margin and premiums; or (2) the aggregate net notional value of commodity futures, commodity options contracts, or swaps positions does not exceed 100 percent of the liquidation value of the pool's portfolio. See id. at 11,283. These amendments, the plaintiffs acknowledge "largely mirror[] the pre-2003 trading threshold, although the net notional test is new." Pls.' Mem. at 10; see also Compl. ¶ 37 (noting that the Final Rule "adopted the trading threshold largely as proposed in the [Notice of Proposed Rulemaking]" and added the "'alternative net notional test'"). The Final Rule also differs from the pre-2003 regulation because it includes trading in swaps as part of the trading thresholds.*fn19

The new marketing restriction under Section 4.5 precludes an entity claiming an exclusion from "marketing participations to the public as or in a commodity pool or otherwise as or in a vehicle for trading in the commodity futures, commodity options, or swaps markets." 77 Fed. Reg. at 11,283. As the plaintiffs also acknowledge, "[a]side from the inclusion of swaps, this is essentially identical to the pre-2003 marketing threshold." Pls.' Mem. at 10.*fn20

In justifying these changes to Section 4.5, the CFTC noted that while excluding certain investment companies from CFTC oversight was once "appropriate because such entities engaged in relatively little derivatives trading, and dealt exclusively with qualified eligible persons, who are considered to possess the resources and expertise to manage their risk exposure, . . . changed circumstances warrant revisions to these rules." 77 Fed. Reg. at 11,275. As support for revising the rules, the CFTC identified, inter alia, "increased derivatives trading activities by entities that have previously been exempted from registration with the Commission, such that entities now offering services substantially identical to those of registered entities are not subject to the same regulatory oversight" as well as the mandate from Dodd-Frank "to manage systemic risk and to ensure safe trading practices by entities involved in the derivatives markets, including qualified eligible persons and other participants in commodity pools." Id.

The CFTC also emphasized that there is currently "no source of reliable information regarding the general use of derivatives by registered investment companies," and the need for that information in order for the newly created FSOC to "perform its statutorily mandated duties," id. at 11,252, 11,275, which include "collect[ing] information from member agencies," "monitor[ing] the financial services marketplace in order to identify potential threats to the financial stability of the United States," and "identify[ing] gaps in regulation that could pose risks to the financial stability of the United States." Dodd-Frank, § 112(a)(1).*fn21

The Final Rule also included new Section 4.27, requiring CPOs and CTAs to report information to the CFTC on forms CPO-PQR and CTA-PR, respectively. Id. at 11,266--67, 11,285--86. The CFTC stated in the Final Rule that, "[b]y creating a reporting regime that makes the operations of commodity pools more transparent to the Commission, the Commission is better able to identify and address potential threats." Id. at 11,281.

In issuing the Final Rule, the CFTC noted that it had heeded the advice of several commenters, including plaintiff ICI, that "obligations flowing from CFTC registration needed further consideration in order to avoid conflict with certain SEC requirements for RICs." Def.'s Mem. at 16. Accordingly, the CFTC, concurrently with issuing the Final Rule, issued a notice of proposed rulemaking to harmonize the CFTC and SEC's compliance requirements. See Proposed Rule, Harmonization of Compliance Obligations for RICs Required to Register as CPOs, 77 Fed. Reg. 11,345 (Feb. 24, 2012) ("Harmonization Proposed Rulemaking"). This harmonization process encompasses compliance obligations in Part 4 of the CFTC's regulations, which are subject to change during the harmonization process, but does not include the requirements set forth in Section 4.27, which the CFTC considers to be final and not subject to change in the pending harmonization rulemaking. See Def.'s Mem. at 16.*fn22

The effective date for Section 4.5 of the Final Rule is April 24, 2012, and for Section 4.27 is July 2, 2012, but compliance with these challenged sections was postponed. See 77 Fed. Reg. at 11,252; Tr. (Oct. 5, 2012) at 45, lines 10-22. Pursuant to the Final Rule, compliance with Section 4.5 for registration purposes only "shall be required not later than the later of December 31, 2012, or 60 days after the effective date of the final rulemaking further defining the term 'swap.'" 77 Fed. Reg. at 11,252. Since the Final Rule on Swaps was published on August 13, 2012, see Joint Final Swaps Rule, Further Definition of "Swap," "Security-Based Swap," and "Security-Based Swap Agreement"; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 Fed. Reg. 48,208, compliance with Section 4.5 for registration purposes is December 31, 2012. See 77 Fed. Reg. at 11,252.

While the effective date for Section 4.27 is specified in the Final Rule to be July 2, 2012, compliance with Section 4.27 for "[e]ntities required to register due to the amendments to § 4.5" is required, along with the other "recordkeeping, reporting, and disclosure requirements pursuant to part 4 of the Commission's regulations within 60 days following the effectiveness of a final rule implementing the Commission's proposed harmonization effort . . . ." Id.; see also id. at 11,271 (already registered CPOs must comply with Section 4.27 by September 15, 2012 or December 15, 2012, depending upon the amount of assets under management). As the defendant made clear in supplemental briefing after the motions hearing, "the Final Rule release suspends compliance with Rule 4.27 for registered investment companies, pending a final harmonization rule. . . . [I]nvestment companies required to register with the Commission pursuant to the amendments to Rule 4.5 need not comply with Rule 4.27 until after the harmonization rule becomes effective." Def.'s Reply to Pls.' Supp. Resp., ECF No. 40, at 3. Thus, although the defendant considers the requirements set forth in Section 4.27 to be final, compliance with Section 4.27 is suspended, as is compliance with the part 4 requirements that are subject to change in the joint harmonization rulemaking. There is no estimated date for the Final Rule on harmonization. See Tr. (Oct. 5, 2012) at 46, lines 18-21.

D.Procedural History

The plaintiffs brought this lawsuit to challenge the CFTC's amendments to Sections 4.5 and 4.27, arguing, inter alia, that, in issuing the Final Rule, "the Commission did not even mention - much less provide a reasoned explanation for abandoning - the rationale behind its 2003 amendment eliminating the trading and marketing thresholds." Compl. ¶ 39. The plaintiffs request that the Court, through an injunction, restore the CFTC's 2003-era financial regulations with respect to RICs. Specifically, the plaintiffs allege in five counts that there was, on the part of the CFTC, (1) insufficient evaluation of costs and benefits in violation of the CEA and the APA (Count I); arbitrary and capricious agency action in violation of the APA by (2) requiring registration and regulation of investment companies and their advisors (Count II);

(3) establishing registration thresholds and adopting related requirements and restrictions (Count III); and (4) failing to provide interested persons a sufficient opportunity to meaningfully participate in the rulemaking (Count IV); and (5) arbitrary and capricious agency action in requiring Form CPO-PQR in violation of the CEA and APA (Count V). The plaintiffs set forth their requested relief in Count VI, arguing that "[t]hese injuries will be redressed only if this Court declares the Rule's amendments to Sections 4.5 and 4.27 and related provisions unlawful and enjoins the CFTC from implementing those amendments." Compl. ¶ 81.

The parties filed cross-motions for summary judgment, see ECF Nos. 8, 15, and presented oral argument on these motions. See Minute Order (Oct. 5, 2012). At the request of the parties, the Court allowed supplemental briefing on issues raised in the motions ...


Buy This Entire Record For $7.95

Download the entire decision to receive the complete text, official citation,
docket number, dissents and concurrences, and footnotes for this case.

Learn more about what you receive with purchase of this case.