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Court Rules Against Industry on Challenge to CFTC Rule 4.5

Today, the Court of Appeals for the DC Circuit upheld CFTC Rule 4.5, which requires most funds investing in commodity-related instruments to register with the CFTC.  The ICI and Chamber of Commerce had challenged the rule immediately after it was adopted, initially in the District Court.  The District Court judge ruled for the CFTC, finding that “The Court is satisfied that the CFTC considered the relevant factors, acted well within its discretion, and that there was nothing arbitrary or capricious about the CFTC’s actions in promulgating the Final Rule.”  The ICI and Chamber of Commerce then appealed the case to the Court of Appeals for the DC Circuit, which upheld the District Court’s opinion.

The decision addressed each challenge put forth by the ICI and Chamber of Commerce, siding with the CFTC in each instance.

Did the CFTC Justify the Change in its Policy?

The first challenge asserted by the ICI and Chamber of Commerce stated that the CFTC failed to give a rationale for changing its policy that previously had provided an exemption from registration for registered investment companies.  The Court of Appeals stated that the “CFTC explicitly acknowledged that it was changing its position from its 2003 rulemaking. The Final Rule detailed the changed circumstances that prompted CFTC to amend the rule, including increased derivatives trading by investment companies (an issue inherently tied to liquidity) and a perceived lack of market transparency that could lead to a buildup of systemic risk.”  Therefore, the Appeals Court found that the CFTC provided enough explanation for the court to “reasonably . . . discern[]” the agency’s path,” and therefore the court had to uphold the regulation, even if the agency’s decision has “less than ideal clarity.”

Did the CFTC Provide an Adequate Evaluation of the Costs and Benefits of the Rule?

The next challenge asserted by the ICI and Chamber of Commerce addressed whether the CFTC had performed an appropriate cost-benefit analysis of the new regulation.  The challenge addressed whether the CFTC had considered whether existing regulatory requirements provided the protections sought by the rule.  The Court of Appeals distinguished the case from two cases overturning rules promulgated by the SEC and agreed with the District Court that the CFTC considered whether “registered investment companies were otherwise regulated and concluded that CFTC regulation was necessary despite the existing SEC regime.”

The ICI and Chamber of Commerce also claimed that because some rules would not be effective until after harmonization of rules with the SEC, it would be “impossible to determine the costs and benefits” of the rule.  The Court of Appeals rejected this argument, finding that the CFTC’s final rule listed the five factors it must consider when evaluating costs and benefits of proposed rulemakings and was not obligated to consider “hypothetical costs that may never arise.”  The Court of Appeals agreed with the District Court that the costs arising under the harmonization of the CFTC and SEC disclosure rules could be challenged once the harmonization rule is released.

Specific Challenges to Particular Aspects of the Rule

In addition to the procedural issues, the ICI and Chamber of Commerce also challenged particular aspects of the CFTC’s rule.  The first challenge was to the CFTC’s inclusion of swaps in the registration threshold, which would require more investment companies to register with the CFTC.  While the DC Circuit found that the CFTC’s response had “less than ideal clarity,” the court found that the CFTC did give sufficient explanations for including swaps.

The appeal also challenged the definition of bona fide hedging contained in the rule as too narrow.  However, the court found that the claim that the definition was too narrow is a “policy disagreement” and rejected the argument.  Further, the court found that the fact that the definition was cross-referenced from a rule that was vacated does not make it automatically invalid.

Finally, the ICI and Chamber of Commerce challenged the rule on the basis that the 5% threshold contained in the rule was too low.  However, the court deferred to the agency’s judgment because the CFTC gave a reasonable explanation for choosing 5%.

Did the CFTC Fail to Provide Adequate Opportunity for Notice and Comment?

Finally, the appeal challenged the rule based on the fact that the proposal did not set out the basis of the cost-benefit analysis included in the final rule.  The Court of Appeals found that because the proposal included a separate section entitle “Cost-Benefit Analysis,” it provided sufficient notice by setting forth “factors that the CFTC would consider and summarizing the expected costs and benefits.”

The appeal also challenged the seven-factor marketing test that was included in the final rule and did not appear in the proposing release.  However, the Court of Appeals found that the test was merely “guidance” by the agency as decisions would be made on a case-by-case basis; therefore, no prior notice of the factors was required. 

The text of the opinion issued by the Court of Appeals can be found here