As a result of the pending expansion of the jurisdiction of the Commodity Futures Trading Commission (CFTC) to include most swaps, some publicly traded real estate investment trusts (REITs) may soon be considered “commodity pools” whose directors or trustees would be subject to CFTC regulation as commodity pool operators (CPOs) and whose investment managers could be subject to CFTC regulation as commodity trading advisors (CTAs).
How Can a REIT Be Subject to CFTC Regulation?
In July 2011, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) amended the Commodity Exchange Act (CEA) to add swaps to the CFTC’s jurisdiction under a broad statutory definition, which includes many of the products REITs use to hedge their interest rate risks. To give effect to this expanded jurisdiction, Congress enacted an expanded version of the CFTC’s long-standing definition of “commodity pool” so that a commodity pool will include “any investment trust, syndicate, or similar form of enterprise operated for the purpose of trading in commodity interests, including any … swap.” Congress also amended the existing definitions of CPO and CTA to include references to swaps. When considered in conjunction with prior CFTC staff positions, these new definitions of commodity pool, CPO and CTA may well capture many publicly traded mortgage REITs, as well as their operators and investment managers, even if they use only a single swap.
These new definitions will not become effective with respect to swaps until after the CFTC and the Securities and Exchange Commission (SEC) jointly adopt final rules to further define the term “swap.” Neither agency has provided definitive guidance as to when this joint rule will be adopted. CFTC Commissioner O’Malia earlier indicated that he expects that a final rule to define “swap” could be adopted as early as June 2012; however, this has not yet happened.
Accordingly, unless the CFTC or its Division of Swap Dealer and Intermediary Oversight (which is responsible for CPO and CTA regulation) provides exemptive relief in the coming months, the directors of and advisers to many publicly traded mortgage REITs may become subject to the CFTC’s jurisdiction due to their use of swaps and required to register with the CFTC as soon as September 2012.
How Has the CFTC’s Staff Historically Viewed REITs?
The CFTC and its staff have broadly interpreted the existing definition of “commodity pool” to include any collective investment vehicle that uses any futures or options on futures, even if they are used only for hedging. On three prior occasions, the CFTC staff found that publicly traded mortgage REITs using futures to hedge interest rate risks fell within the definition of “commodity pool.” In each case, the REIT’s directors or trustees sought no-action relief in order to avoid being registered with and regulated by the CFTC as CPOs, with the REITs’ investment managers or the REIT employees responsible for investment advice also seeking no-action relief from registration with the CFTC as CTAs.
In spite of the CFTC staff’s broad interpretation of the term “commodity pool,” many publicly traded mortgage REITs historically have not been concerned with commodity pool status or its attendant CPO registration concerns because they have used products other than exchange-traded futures, such as rate caps or over-the-counter bilateral swaps, to hedge their interest rate risks. Likewise, investment managers of these REITs have not had to consider CTA status or registration because their investment advice has not concerned CFTC-regulated products. This is about to change for many publicly traded mortgage REITs with the CFTC’s expanded jurisdiction over swaps.
What About Equity REITs?
Although the CFTC staff’s reasons for concluding that the REITs in these no-action letters were commodity pools were not expressly limited to mortgage REITs, the reasoning seems less applicable to equity REITs, which tend to conduct their business in a manner more similar to an operating company (e.g. primarily owning real assets as opposed to real-estate-related securities). Moreover, in a recent rulemaking defining the term “eligible contract participant,” the CFTC referred to “entities other than commodity pools (e.g., operating companies),” signaling that the CFTC does not consider operating companies to be commodity pools and, while not free from doubt, providing a potential basis for relief to publicly traded equity REITs that behave like operating companies.
Who Is Required to Register as a CPO or CTA?
If a REIT falls within the “commodity pool” definition, a threshold question will be who is required to be registered and regulated as the CPO of the REIT. The CFTC has long relied upon the same core questions to identify the CPO of a commodity pool: Who will be promoting the pool by soliciting, accepting or receiving from others property for the purpose of commodity interest trading? Who will have the authority to hire and fire the pool’s trading advisor? And who will have the ability to select and change the pool’s futures commission merchant? When these questions previously were applied to publicly traded mortgage REITs that were organized as corporations, the CFTC staff reached the conclusion that each corporation’s directors were the CPOs of the REIT.
In each of these situations, CFTC staff provided no-action relief that relieved the directors from CPO registration. Unfortunately, an express CFTC rule precludes any person other than the recipient of a no-action letter from relying upon the relief granted in such letter. Therefore, directors and trustees of publicly traded REITs that might become commodity pools by virtue of their use of swaps likely would need to seek their own no-action relief from CPO registration.
The CFTC staff also has viewed investment managers that provide REITs with advice with respect to commodity interests as falling within the CTA definition. For internally managed REITs, the CFTC staff also has found that the individuals employed by the REIT who provide advice with respect to commodity interests fall within the CTA definition. In each of these situations, though, neither the investment managers nor the REIT employees provided commodity interest trading advice to more than 15 persons nor did they hold themselves out generally to the public as CTAs; therefore, each could rely on an exemption from CTA registration pursuant to Section 4m(1) of the CEA.
What Will Registration Mean for Entities That Will Become CPOs or CTAs to REITs?
Registration with the CFTC requires the completion of a Form 7-R Firm Application for the CPO/ CTA and the completion of a Form 8-R Individual Application for each principal and each associated person (AP) of the CPO/CTA. In addition, each individual completing a Form 8-R must submit fingerprint cards (for FBI background checks), and each individual applying to become an AP generally must satisfy proficiency examination requirements.
Registered CPOs and CTAs also have numerous compliance obligations. For example, a disclosure document must be prepared by most registered CPOs and CTAs and must satisfy the requirements of CFTC Rules 4.24 and 4.25 (for CPOs) or Rules 4.34 and 4.35 (for CTAs). A prospective investor or advisory client generally must provide a signed acknowledgment of receipt of a disclosure document before the CPO or CTA can accept or receive funds. Registered CPOs generally must distribute a monthly account statement with respect to the pool to each investor and submit an audited annual financial report with respect to the pool to each investor as well as to the CFTC and the National Futures Association (NFA).
In addition, all registered CPOs and CTAs, including the registered CPOs and CTAs of a REIT, also are required to file the CFTC’s new systemic risk reporting forms, Form CPO-PQR and CTA-PR, respectively. Form CPO-PQR is a comprehensive report of information about the CPO and the pools operated by the CPO. The frequency with which a CPO must file a Form CPO-PQR and which schedules of Form CPO-PQR must be completed are determined by the CPO’s pool assets under management. “Large CPOs,” which are defined as CPOs that had at least $1.5 billion in aggregated pool assets under management as of the close of business on any day during their reporting period (which is a calendar quarter), must file on a quarterly basis all schedules of Form CPO-PQR. All other CPOs must annually file certain of the schedules. All registered CTAs will be required to file Form CTA-PR annually.
All registered CPOs and CTAs also must become members of the NFA. As NFA members, CPOs and CTAs must comply with the NFA rules and bylaws, which prescribe compliance requirements (such as employee supervision and business continuity planning) and create potential liability through rules that require members to “observe high standards of commercial honor and just and equitable principles of trade.” In addition, all registered CPOs and CTAs are required to complete an annual CFTC/NFA registration update and an annual NFA questionnaire. Members of the NFA also are subject to periodic examinations and audits.
Is Relief Available to CPOs of Publicly Traded REITs?
While the expansion of the CFTC’s jurisdiction may require the directors of certain publicly traded REITs and their advisers to register as CPOs and CTAs, the CFTC in 2011 adopted Rule 4.12(c) to ease the disclosure, reporting and recordkeeping requirements for registered CPOs of commodity pools whose shares are (1) offered and sold pursuant to an effective registration statement under the Securities Act of 1933 and (2) listed for trading on a national securities exchange registered as such under the Securities Exchange Act of 1934.
CPOs whose pools meet the eligibility criteria described above, subject to certain conditions, may claim exemption from:
- the requirement that a disclosure document be delivered and the CPO receive a signed acknowledgment prior to accepting the prospective investor’s funds;
- the requirement that a monthly account statement be distributed directly to each investor in the pool; and
- the requirement that a CPO maintain its records at its main business office.
What Actions Should Publicly Traded Mortgage REITs Consider?
Given the significant implications of registration as a CPO and CTA, publicly traded mortgage REITs and their advisers who may become subject to the CFTC’s jurisdiction as a result of their use of swaps, will need to begin considering whether the regulatory implications of CFTC registration are outweighed by the operational benefit to the REIT from swaps usage. If so, REITs and their advisers will want to familiarize themselves with the CFTC’s CPO and CTA regulations as soon as possible in order to implement in a timely fashion the procedures and programs necessary to comply with the CEA or, alternatively, to consider seeking no-action relief from the CFTC.