On October 28, 2002, the Commodity Futures Trading Commission ("CFTC") proposed an amendment [1] to its Rule 4.5 (the "Rule") adding an alternative limitation on the non-hedge futures and options activities of registered investment companies. The proposed alternative standard would permit registered funds to engage in non-hedge [2] trading in commodity futures and options provided the aggregate notional values [3] do not exceed the liquidation value of their portfolios.

Currently, the Rule permits funds to trade commodity futures and options without having to register with the CFTC as "commodity pool operators" if they restrict their non-hedge trading to positions with an aggregate initial margin or premiums not exceeding 5% of the liquidation value of the fund (the "5% Test"). Recently, the 5% Test has generated concern from the fund industry as margin levels for certain stock index futures have come to significantly exceed 5%. The CFTC has responded to this concern by proposing the new alternative to the 5% Test, which would in effect allow futures contracts with margins above traditional levels -- such as security futures products which have margins in the 20% range -- to be utilized by a fund to the same general extent as other futures.

The proposed amendment illustrates two examples that show the different effects of the 5% Test and proposed alternative standard by using futures contracts based on equity (the S&P 500 Stock Price Index), in one instance, and on debt (the 10-Year Treasury Note), in the other instance. The calculation [4] shows that for establishing positions in the S&P 500 Stock Price Index, the proposed alternative test would be more beneficial to the fund by permitting 48 contracts as compared to 28 contracts under the 5% Test. However, for positions in the 10-Year Treasury Note contract, the calculation shows that the 5% Test would be more beneficial by permitting 284 contracts as compared to 87 contracts under the proposed alternative standard. Given these widely different outcomes, a fund may utilize whichever test it prefers for its particular non-hedge investment strategy at that time.

In addition, the CFTC adopted a no-action position to permit funds to rely on the proposed alternative standard immediately. A fund need not take any additional action with the CFTC to utilize the proposed alternative standard in its non-hedge investment strategy. Board approval and prospectus or SAI revisions would likely be necessary. Neither the existing Rule, the proposed amendment, nor the no-action relief in any way constrains a fund from engaging in unlimited trading for bona fide hedging purposes.

If you have any questions or would like additional information regarding the above matters, please do not hesitate to contact any practice group member.

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