Direct Participation Programs

The next level up in size and complexity is direct participation programs, or DPPs. You may think of them as tax shelters or limited partnerships (LPs). They are constructed to pass through all of their income, gains, losses, and tax benefits to their owners. The partnership itself pays no taxes because the partners accept liability. Gas-oil exploration and real estate development are common LPs.

Unlike those big sisters, the commodity trading limited partnership is not a tax shelter. It is structured to provide limited liability to investors. The syndicator is the CTA or a CPO, and usually the general partner as well. These can be public or private. Private LPs are usually formed by a small group of wealthy investors, while public LPs attract large numbers of small ($2,000 to $5,000 minimum) investors. The latter requires a full-fledged prospectus and is more stringently watched by federal regulators. Both must be registered with the SEC.

The advantage to the investor is limited liability. The maximum loss is the amount invested. The negative side is liquidity. There is not always an active aftermarket for LP interests. Once in, you may have problems getting out. Also, the gains and losses are considered passive and can be used only to offset other passive losses or gains. The general partner, which may be a corporation, assumes the overall risk, but these programs often include a 50 percent deadman switch. If the losses reach or exceed 50 percent of the equity, trading ceases. This is a common feature in just about all programs to protect the CTA as well as the investors.

The private LP is an excellent vehicle for a close-knit group of 10 or so wealthy investors. Each, for example, contributes a half million dollars. With a total pool of $5 million, it is economical to hire a trading manager to select and monitor several CTAs. The size helps manage the systematic risk of the futures market.

Regulation D Offering

There are certain classes of securities that are exempt from the Securities Act of 1933. One of these, commonly used as an investment medium to trade futures, is known as Reg D Offerings. Regulation D of the 1933 Act covers private placements. Under Reg D is Rule 506, which exempts issues from SEC registration if they are sold to no more than 35 nonaccredited or unqualified investors.

A qualified investor has a net worth of $1 million or more, has made at least $200,000 or more in each of the two preceding years (or $300,000 if jointly with spouse), and has a reasonable expectation of making that much again in the year of investment. In other words, only the wealthy need apply. The reason is the lawmakers felt that if you amassed $1 million in net worth, you could protect yourself. It’s interesting to note that the $1 million figure has not been adjusted for inflation since 1933. What a difference six decades has made to the buying power of a million bucks!

There was no exemption given to the type of information an investor must receive nor to the tax, fraud, and misrepresentation portion of the Act. A private placement memo replaces the traditional prospectus. The reason why this type of offering is popular is the reduced cost of a full-fledged SEC registration and that there is no limitation on the amount that can be raised. The downside to the investor is illiquidity, but liability is limited to the amount invested.

A first cousin of Reg D is the Rule 147 offering. These are sold entirely in one state and are exempt from SEC registration under Rule 147. The state commissioner of securities has jurisdiction. Once again, liquidity can be a problem for investors. As with the Reg D, a private placement memorandum details the offering.

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Managed Futures Paperwork and Other Regulatory Matters continue…

• Managed Futures Paperwork and Other Regulatory Matters
• Selecting a Baseline Measurement for CTA Success Part 1
• Relating Familiar Marketing Techniques to Managed Derivatives Targets
• The Origins of the Futures Industry (part 1)
• The Origins of the Futures Industry (part 3)
• Relating Familiar Marketing Techniques to Managed Derivatives Targets
• Futures Contracts
• Selecting a Baseline Measurement for CTA Success Part 3
• Regulation of Managed Futures Funds in the US and Japan
• Regulation of Managed Futures Funds in the US and Japan