SEC Division of Investment Management staff letter: Managed Futures Association

No Action Request

Investment Company

Act of 1940

Sections 3 (a) (1) ,
3 (a) (3) and 3 (b) (1)
MANAGED FUTURES ASSOCIATION
July II, 1996

.l(' t4
ACT
Mr. Jack W. Murphy 3~l )(3)/ 3(6)(/)
SECTION Associate Director and Chief Counsel

Division of Investment Management RULE

Securi ties and Exchange Commission PUBÍC 450 Fifth Street, N. W.

Washington, D. C. 20549
AVAILABILITY -'/IS-/tlt / ,
Re: "No Action Letter" Request Relating to the Status Under the Investment Company Act of 1940

of Certain "Commodity Pool" Funds of Funds

Dear Mr. Murphy:

The Managed Futures Association (the "MFA") i is submitting this "No Action Letter" request under the Investment

Company Act of 1940, as amended, and the regulations promulgated

thereunder (the "Act"), to the Division of Investment Management

(the "Division") of the Securities and Exchange Commission (the

"SEC" or the "Commission"), to ask that the Division confirm by

letter that it will not recommend enforcement action to the

Commission if a class of commodity pools structured as "funds of

funds" operate without registration under the Act as investment

companies. The MFA is seeking general "No Action'- relief in

order to provide the managed futures industry with guidance

concerning the ability of commodity pool operators ("CPOs") to

structure "funds of funds" commodity pools while ensuring that

these pools not be deemed to constitute investment companies

required to be registered under the Act. This submission is

based on (i) a belief that the Staff should "look through"

commodity pools' "funds of funds" investments in "second-tier"

commodity pools to the underlying economic activity of such

"second-tier" pools and (ii) the "otherwise regulated" character

of both commodity pool "funds of funds" and the "second-tier funds" in which they invest. Limited Scope of Request

The MFA has purposefully formulated this request

restricting the "No Action" relief being sought solely to

commodity pools that are (A) sponsored and operated by CPOs

registered under the Commodity Exchange Act, as amended, and the

regulations promulgated thereunder (the "CEA") and (B) primarily

engaged in trading "commodity interest contracts," (i) directly

through managed accounts, (ii) through investing, directly or

i The MFA is the not-for-profit national trade association representing the managed futures industry. The MFA membership includes the sponsors, trading advisors and commodity brokers for substantially all of the commodity pools marketed on either a public or a private basis in the United States. GOVERNMENT RELATIONS: 1150 CONNECTICUT AVENUE, N.W., SUITE 700 · WASHINGTON, D. C. 20036 · TEL: 202-872-9186 · FAX: 202-872-9189

Securities and Exchange Commission

February 15, 1996

indirectly, in other commodity pools which meet the criteria in A

and B (just as do the investing pools themselves) or (iii) a

combination of (i) and (ii). The focus of this request is on the

ability of "otherwise regulated" "funds of funds" to evaluate

their primary purpose under the Act by "looking through" the

commodity pools in which they invest to the underlying commodity i' are interest contract trading in which such "second-tier funds

themselves primarily engaged. The context of this request

involves entities whose substantive economic activity is trading

commodity interest contracts, not securities. This is not a

context in which the MFA believes that there should be any

meaningful regulatory incentive or justification for applying the

literal terms of the Act, while the adverse effects of not

granting the requested relief have been, are now, and are

becoming increasingly, onerous to the managed futures industry.

The Need for Relief

The Act cannot regulate commodity pool "funds of

funds"; it can only prohibit them. There are numerous provisions

in the Act which are fundamentally inconsistent with the

operation of the typical "commodity pool. ,,2 It is against the

reality of prohibition, not regulation, that the need for relief

must be evaluated. At the same time, it must be made clear that,

while commodity pool "funds of funds" are fundamentally

incompatible with the Act, this structure is, due to its utility

and efficiency, in widespread and routine use as "8- means of

structuring commodity pools in financial markets outside of the

United States. The applicability of the Act in strict accordance

with its terms, to the "funds of funds" structure has become

a major impediment and competitive disadvantage to the United

States managed futures industry -- despite the clear objective of

these "funds of funds" primarily to trade instruments which are

not regulated by the Commission.

The need for "funds of funds" relief under the Act is

acute. Principal among the reasons for the urgency of this

request is the fact that many of the more experienced and

successful "commodity trading advisors" ("CTAs") can only be

accessed by investing in a pooled entity (typically organized and

operated by the CTAsthemsel ves). There are many advantages for

a CTA in managing a single pool rather than a plethora of

individual managed accounts. In managing a single account, aCTA

need not be concerned with inadvertently treating one account

inequi tably as compared to another; the CTA is able to enter and

exit markets more efficiently and generally obtain better

executions by entering one, rather than numerous orders; the CTA

has only one aCcount for which trade reconciliations need be

made; the CTA has only one account requiring trade confirmations

2 For example, the Act's restrictions on paying incentive fees, leverage, and "senior securities" as well as investor liquidity, among others, conflict with the basic models used for United States commodity pools.

Securities and Exchange Commission

February 15, 1996

and monthly statements; and regulatory compliance and performance

computations are dramatically simplified.3 In addition, managed

accounts are disfavored, as compared to pools, by CTAs seeking to

preserve the confidentiality of trading systems, and who fear

that unscrupulous clients in possession of trade data (managed

account clients must, by law, be given daily confirmations of all trading acti vi ty in their accounts; an, investor in a private fund receives a net asset value report instead - - the fund and the CTA

being the only recipients of trade confirmations) might attempt

to "reverse engineer" the CTAs' trading systems (with the intent

of trading against or ahead of these systems) or disclose their

open positions to other traders.

It is not only the CTAs which benefit from "pooling"

clients' funds. Investors themselves benefit from the reduced

administrative costs, enhanced accuracy and greater efficiency in

order execution and allocation. A managed account also has the

distinct disadvantage that it exposes investors to unlimited

liability - - a particularly important drawback from the

perspective of investor protection given the high degree of

leverage available in futures trading and the very real chance of

incurring a deficit balance. However; perhaps the greatest

is that pooled vehicles permit clients

to obtain professional management of their capital which would

otherwise be unavailable to them. Many maj or CTAs currently have

minimum account si.zes of $5 million. This required minimum

capital commitment precludes even certain of the ..rger multi-

advisor pools from placing assets directly with such CTAs, while

were such pools able to invest in a pooled entity, the minimum

investment in such entity could be much smaller.

client benefit of pooling

Despite the fact that commodity pool "second-tier

funds" operate, both in substance and in intent, as conduits to

their CTAs' commodity interest contract trading, under current

law the nature of the economic activity of the investing "funds

of funds" is transformed for regulatory purposes from what it

really is - - commodity interest contract trading - - to what it

really is not -- investing in securities -- merely as a result öf

the "fund of funds" structure. A pool which trades commodity

interest contracts directly' is clearly not an investment company.

However, if the same commodity pool accesses a CTA through a

"second-tier" commodity pool, operated by a registered CPO, the

investment in the "second-tier" entity is no longer treated as

commodity interest contract trading, but as an investment in

3 Under the CEA, it is necessary to have established the methodology by which "bulk orders" will be allocated among the individual client accounts participating in the bulk order before the trade is transmitted to the exchange floor for execution. It is not permitted, as it is in the case of securities accounts, to allocate positions at the end of the trading day so as to achieve an equitable or "average price" allocation of trade "fills." Consequently, different managed accounts traded pursuant to the same managed futures program frequently experience materially different cumulative performance over time, simply due to order allocations.

Securities and Exchange Commission

February 15, 1996

securities. Such an investment - - at least if in excess of 25%

of the "fund of funds" commodity pool's assets (see Ft. Trvon

Futures Fund Limited Partnership, available August 16, 1990)

potentially causes the investing commodity pool - - despite the

economic substance of its trading program -- to fall within the

definition of an investment company, thereby effectively

precluding the investment. The MFA believes there is no

justification for this result. Provided that the "second-tier

fund" primarily trades "commodity interest contracts" as proposed

in this "No Action" request, there is no possibility for abuse.

The harm to the managed futures industry and to its

clients from commodity pools not' being able to access CTAs

through "second-tier funds," operated by registered CPOs, as

opposed to managed accounts, is material. Indeed, so material

no doubt,

and must be grave concern, that the United States managed futures

industry will be crippled by the continued loss of many of the

industry's most successful money managers who are no longer

willing to manage U. S. investor capital. The draconian

consequences of being held in violation of the Act - - including

rescission liability - - combined with the current uncertainty of

the distinction between commodity pools and investment companies

has an in terrorem effect which drives talented CPOs and CTAs to

manage only offshore money, despite the underlying economic

activity of the CPOs and CTAs clearly focusing on trading

commodity interest contracts, rather than securi~s. No

regulatory purpose can be served by compelling CPOs who wish to

access the most successful CTAs to do so only on behalf of

foreign investors, while U. S. persons effect i vely are precluded

from investing in commodity pools sponsored by such CTAs because

their doing so causes their portfolio objective to be recast

purely for regulatory purposes, not in terms of economic

substance -- into securities investing rather than commodity

interest contract trading.

that in the absence of "No Action" relief, there can be

Safeguards Against Abuse as a Result of the Otherwise

Requlated Status of Commodity Pool II Funds of Funds" In order to ensure that the proposed exemption is only

available to appropriate pools, the MFA proposes that each of the

investor and investee pools must be managed by a CPO registered

under the CEA. The .CEA imposes disclosure, reporting and

recordkeeping requirements, as well as providing for regular

audits conducted by the National Futures Association, the self-

regulatory body of the United States managed futures industry.

In addition, the CEA provides investors with a panoply of

administrative, arbitral and.judicial remedies, in conjunction

with an explicit "private right of action." Because these

commodity pools are already comprehensively regulated by the

CFTC, the agency presumptively expert in their operation, any

abuses which might arise from .this structure can be dealt with by

the CFTC which has broad authority under the CEA to take

appropriate action. Such relief will not result in carving out

Securities and Exchange Commission

February 15, 1996

an unregulated sector of the financial markets, but rather

acknowledges that the commodity pool "funds of funds" in question

are subject to the jurisdiction of their primary federal regulator. Conclusion In the case of commodity pool "funds of funds" in which

all "second-tier funds" are primarily engaged in trading

commodity interest contracts rather than securities, and in which

the "funds of funds" themselves are (through investing in such

"second-tier funds" or directly through managed accounts)

primarily engaged in trading commodity interest contracts, the

MFA respectfully requests the Staff to confirm that it would not

recommend enforcement action to the Commission if such "funds of

funds" operate without registration under the Act. To grant such

relief would .be to permit regulation on the basis of the

substantive economic activity while at the same time removing a

major impediment to the continued pre-eminence of the managed

futures industry. This can be readily accomplished, without need

of amending any of the terms or the policies of the Act t by

adopting a "look through" analysis and permitting commodity pool

"funds of funds" to be regulated not by the Act, but by the CEA

• the statute specifically enacted to govern the commodity

United States entities which

trade in such markets.

interest contract markets as well as

i￾The MFA, and the managed futures industry which it

represents, much appreciate the Staff's attention to these

matters. If you have any questions regarding the foregoing or

desire any additional information, please contact the undersigned

at (202) 872-9186.

Due to the importance of this issue to the industry, we

do not request confidential treatment for this submission, unless

the Staff feels that such treatment would be appropriate.

In accordance with Release No. IC-6330, we herewith

submit this original letter plus six copies.

Respectfully submitted,

-."' s. ~ Johi.1 G. Gaine
General Counsel

Director, Government Relations

Managed Futures Association

JUL I 5 1996

Our Ref. No. 96-94

Managed Futures

RESPONSE OF THE OFFICE OF CHIEF COUNSEL, Association DIVISION OF INVESTMENT MAAGEMENT File No. 132-3

Your letter dated July 11, 1996, requests our assurance that

that the Commission take any enforcement

action if certain commodity pools operate in the manner described

we would not recommend

in your letter without registering as investment companies under

the Investment Company Act of 1940 (" Investment Company Act") . The Managed Futures Association (the "MFA") is a national

trade association representing the managed futures industry. The

MFA's members include the sponsors, trading advisers and

commodity brokers for the publicly and privately marketed

commodity pools in the United States. The MFA is seeking no-

action relief under the Investment Company Act to permit certain

commodity pools to invest some or all of their assets in

interests of other commodity pools ("second-tier pools"), without

registering as investment companies under the Investment Company

Act.
You represent that the requested relief is necessary to

enable commodity pools to obtain the expertise of many of the

more experienced and successful commodity trading advisors

("CTAs") who increasingly prefer to advise their clients to

. i- invest in a single managed trading account - - the second-tier pool - - rather than manage numerous separate client accounts.

You represent that a single managed trading account presents a

number of operational advantages for a CTA. In using such an

account, for example, the CTA need not be concerned with

inadvertently treating one account more favorably than another.

The CTA is also able to enter and exit markets more easily and to

obtain more favorable executions by placing a single order rather

than multiple orders. In addition, the CTA has only one account

for which trade reconciliations need to be made and for which

trade confirmations and monthly statements are required to be

delivered. i You further represent that managing a single pooled

account may help successful CTAs keep their trading strategies confidential. You represent that under the Commodity Exchange Act

("CEA"), a CTA must establish a methodology for

allocating "bulk orders" among its individual client

accounts before the bulk order or trade is made, and

that consequently, different accoúnts managed by the

same CTA may experience materially different cumulative

performance over time simply due to order allocations.

You represent that a single account eliminates inequities due to the order of trade allocations.

You assert that this pooling of client accounts benefits a

CTA's clients as well. You note that when a commodity pool

invests in futures contracts directly, the pool is exposed to

unlimited liability for losses on those contracts. In contrast,

by investing through a second-tier pool (typically a limited

partnership), a pool can obtain limited liability and some degree

of protection from the substantial risk created by the high

degree of leverage available in the futures markets.

You state that this two-tiered commodity pool structure

raises issues under the Investment Company Act. Specifically,

because passive interests in second-tier pools likely would be

deemed to be securities under the Investment Company Act,2 a

commodity pool investing through second- tier pools may fall

within the definition of "investment company" under Sections

3(a) (1) and 3(a) (3).3 You note, however, that registration under and compliance with the Investment Company Act are impractical

for most commodity pools, because there are numerous provisions

of the Investment Company Act that are fundamentally il)consistent

with the operation of a typical commodity pool. 4 .

You propose that, in the case of a commodity pool that (1)

is sponsored and operated by a commodity pool operator ("CPO")

registered as such under the CEA, and (2) invests some or all of

2 Section 2 (a) (36) of the Investment Com~y Act defines "security" to include, among other things, any note,

stock, treasury stock, bond, debenture, evidence of

indebtedness, or certificate of interest or

participation in any profit-sharing agreement.

3 Section 3 (a) (1) defines "investment company" to include any issuer which "is or holds itself out as being

engaged primarily, or proposes to engage primarily, in

the business of investing, reinvesting, or trading in

securities. " Section 3 (a) (3) defines "investment

company" to include any issuer which "is engaged or

proposes to engage in the business of investing,

reinvesting, owning, holding, or trading in securities,

and owns or proposes to acquire investment securities

having a value exceeding 40 per centum of the value of

such issuer's total assets (exclusive of Government

securities and cash items) on an unconsolidated basis."

Securities issued by commodity pools are "investment

securities" for purposes of Section 3 (a) (3) .
4 You represent that the Investment Company Act's

restrictions relating to, among other things, liquidity

of portfolio investments, the use of leverage, and the

issuance of senior securities would conflict with the

operations of most U. S. commodity pools.

its assets in second-tier pools that (i) are not investment

companies, and (ii) are sponsored and operated by CPOs registered

as such under the CEA, the CPO of such a pool be permitted to

"look through" its investments in the second-tier pools to the

second-tier pools' investments for purposes of determining

whether the pool meets the definition of an investment company.

You note that a pool that primarily invests directly in commodity

interests is not deemed to be an investment company. You

maintain that when the same pool uses one or more second-tier

pools as conduits to access the commodities trading expertise of

particular CTAs, the nature of the pool's investments is

unchanged - - it remains essentially an investment in commodity interests. You represent that the operators of pools for which you seek

relief are subj ect to comprehensive regulation by the Commodity

Futures Trading Commission ("CFTC") pursuant to the CEA. As a

result, you maintain that regulation of such pools under the

Investment Company Act is both duplicative and unnecessary. You

assert that such pools are held out to the public as commodity

pools regulated by the CFTC and not as investment companies under

the regulation of the Commission. Finally, you submit that for

these reasons, there is no justification for subjecting the pool

to different regulatory schemes depending upon whether it invests

in commodity interests directly or through one or more second-

tier pools. t￾Analysis
Many commodity pools that are held out to the public as such

can meet the definition of investment company in Section 3 (a) (3) in view of the nature of their business. 5 A commodity pool that

meets the definition of investment company in Section 3 (a) (3) nonetheless may be excluded by Section 3 (b) of the Investment Company Act. Section 3 (b) (1) excludes from the definition of

investment company any issuer engaged primarily in a business or

businesses other than investing, reinvesting, owning, holding or

5 We understand that the assets of commodity pools

typically consist in large part of cash and government

securi ties, which are used to margin futures contract obligations. Because cash and government securities

are excluded from total assets for purposes of applying
Section 3 (a) (3), any other securities held by a
commodity pool become a significant percentage of the

pool's total assets, causing the pool to meet the

definition of investment company contained in that
section.

trading in securities, either directly or through wholly-owned subsidiaries.6 In Tonopah Mining Co. of Nevada ("Tonopah"), 7 the Commission

adopted a five factor analysis for determining an issuer's

primary business for purposes of assessing the issuer's status

under the Investment Company Act. Although the Commission

decided Tonopah under Section 3 (b) (2) of the Investment Company

Act8, the same factors are relevant to determining an issuer's

primary business under Section 3 (b) (1).9 These factors are: (1)

the company's historical development; (2) its public

representations of policy; (3) the activities of its officers and

directors; (4) the nature of its present assets; and (5) the

source of its present income. In Tonopah, the Commission

accorded the fourth and fifth factors the most weight.

The staff has recognized that a commodity pool's balance

sheet may not necessarily be a useful indicator of the pool's

primary business for purposes of assessing the pool's status

under the Investment Company Act. The staff has taken the

6 Section 3 (b) does not exclude issuers meeting the definition of investment company in Section 3 (a) (1) . If an issuer is found to be "primarily engaged" in a

business other than investing, reinvesting, owning, holding, or trading in securities for ~poses of
Section 3 (b) (1), however, it necessarily will be

engaged primarily in a business other than investing,

reinvesting, or trading in securities for purposes of

Section 3 (a) (1). Therefore, unless an issuer holds
itself out as being primarily engaged in the business

of investing, reinvesting, or trading in securities, a

determination that an issuer meets the standards for

exclusion under Section 3 (b) is, by definition, a

determination that it is not an investment company

under Section 3 (a) (1). See ICOS Corporation: Order

Granting Exemption. Investment Company Act Release No.

19334 (Mar. 16, 1993); M. A. Hanna Co., 10 S.E.C. 581

(1941) .
7 26 S.E.C. 426 (1947).
8 Section 3 (b) (2) authorizes the Commission to issue orders excluding issuers engaged primarily in a business or businesses other than investing, reinvesting, owning, holding, or trading in securities

directly, through maj ority-owned subsidiaries, and

through certain controlled companies.

9 See Investment Company Act Release No. 10937 (Nov. 13,
1979) (proposing Rule 3a-1), n.24.

position, therefore, that in determining the primary business of

a commodity pool, the most important factor to be considered is

the portion of the pool's business with respect to which it

anticipates realization of the greatest gains and exposure to the

largest risk of loss. 10 In our view, therefore, a commodity

pool's primary business should be deemed to be investing or

trading in commodity interests if (1) the pool looks primarily to

commodity interests as its principal intended source of gains,

(2) the pool anticipates that commodity interests present the

primary risk of loss, and (3) the pool's historical development,

public representations of policy (in its prospectus or offering

circular and in marketing materials), and the activities of those

charged with management of the pool demonstrate that the pool's

primary business is investing or trading in commodity interests, rather than securities. Without necessarily agreeing with your legal analysis, we

would not recommend that the Commission take any enforcement

action under the Investment Company Act if, when assessing for

purposes of Section 3 (b) (1) whether or not a commodity pool is primarily engaged in the business of trading or investing in

commodity interests, the commodity pool "looks through" the

second-tier pools in which it has invested and treats the

business activities of each second-tier pool as having been

engaged in directly by the commodity pool itself, provided that

registered as such

under the CEA, and (2) each second-tier pool (i) ás operated by a

CPO registered as such under the CEA, and (ii) is not an

investment company, and is not excluded from regulation under the

(1) the commodity pool is operated by a CPO

Investment Company Act by Section 3 (c) (1) thereof. 11 Because the position set forth above is based on the facts

and representations in your letter, you should be aware that

different facts and representations may require a different

result.12 Moreover, this response expresses the Division's views

10 Peavey Commodi ty Futures Fund (pub. avail. June 2,
1983) ("Peavey").
11 The position taken in this letter should not be read to provide any relief from the Section 3 (a) (1) definition of investment company to any commodity pool that holds

itself out as being primarily engaged in the business of investing, reinvesting or trading in securities. Such a commodity pool would be an investment company

under the Investment Company Act. .

12 We recognize that this position requires an analysis of

the primary business activities of each second-tier pool under Peavey. In determining the nature of the (continued. . . )

on enforcement action only and does not purport to express any 1~8k~ questions presented.13 Phillip S. Gillespie

Senior Counsel

'..
12 ( . . . continued) business activities of a second-tier pool, however, a

commodity pool may, in our view, rely on

representations made in the prospectus or other

offering documents of such second-tier pool and on the

representations of the second- tier pool's CPO, unless

the commodity pool's CPO knows or has reason to know

that such representations do not accurately reflect the

nature of the second-tier pool's business activities.

In performing an analysis òf its primary business

activities under Peavey, a second-tier pool that

invests in other commodity pools may likewise "look

through" to the business activities of the pools in

which it has invested in accordance with the terms of this letter. 13 This response in no way addresses the status of

interests in second-tier pools as securities for

purposes of the Securities Act of 1933, the Securities

Exchange Act of 1934, the Investment Advisers Act of

1940, or other provisions of the Investment Company

Act.