Given the cannabidiol (CBD) from hemp or hemp flower business explosion, privately-owned hemp and CBD-from hemp businesses may buy and sell hemp futures while engaging in its regular line of business—creating and producing CBD from hemp and other hemp products, including smokable hemp flower—effectively expanding the commodification of the “flower.” Traditionally, such “in-house” futures trading was permissible in two ways: (1) hire a trader internally to buy and sell futures; or (2) create a separate entity to buy and sell futures. A company’s preferred choice depended upon two factors: (1) the business or its affiliate is deemed a commodity pool; or (2) the business’ commodity pool operator (CPO) and/or commodity trading advisor (CTA) would have to register with the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA).

A Hemp Futures Exchange’s Regulatory Underpinnings

A “commodity pool” is an investment trust, firm, or other business, operating for the purpose of trading commodities such as futures, raising capital or “pools” investments through the sale of shares or limited partnerships, using capital to invest entirely or partially in commodity contracts by trading like a hedge or private equity fund. See 7 U.S.C. §2; 13 Commodities Reg. §17A:1; and Lopez v. Dean Witter Reynolds, 805 F.2d 880, 884 (9th Cir. 1986).

A commodity pool is organized as a separate corporate entity—often as a limited partnership—to limit liability to the investment and avoid unlimited liability of individual traders. See id. Similarly, a collective investment vehicle, trading commodity interests only indirectly through another pool, is also deemed a commodity pool, sometimes called a “fund-of-funds.” The commodity pool operator must operate the pool through a separate entity. 17 C.F.R. §4.20(a)(1). However, an exemption may exist to commodity pool registration, if there is a separate entity, that has: (1) a separate principal and manager; (2) all trading uses revenue or capital separate from business investment capital; (3) the trader is delegated responsibility for operating and trading; (4) no additional investor solicitation; and (5) the trader electronically files a notice of exemption from CPO registration, indicating the new entity is not a commodity pool.

The trader and its principal must observe all corporate formalities and refrain from commingling trading funds with business accounts or assets. This separate entity may qualify for the small pool registration exemption, requiring: (1) none of the manager operated pools has more than 15 participants, and (2) total gross capital contributions received from investors not exceed $400,000, excluding contributions from the manager or related investments but all operations, trading, and advisory duties should be delegated and a notice of exemption electronically filed.

The business should only use its business income/revenue for investment purposes, not the investment its owners use to capitalize the company. If the business’ own investment capital is used, it is using “pooled” investments “for the purposes of trading,” and likely a commodity pool “fund of funds.” Thus, using its business income/revenue means that the business is not utilizing “pooled” investments, further distancing itself from the definition of a commodity “pool.” Finally, to ensure limited liability, the business should not commingle its non-trading assets with that of the new entity under any circumstances.

A CPO is an individual or organization that “solicits, accepts, or receives from others, funds … for the purpose of trading in commodity interests.” 7 U.S.C. §la(11)(A)(i). “[T]he statute does not require a commodity pool operator to execute commodity futures transactions.” CFTC v. Equity Financial Group, 572 F.3d 150, 158 (3d Cir. 2009). The Commodity Exchange Act regulates CPOs, assuming the business is a commodity pool, the trader will act as a CPO. The CPO is not merely an “agent” of the commodity pool, regardless of the commodity pool structure. See CFTC v. Amerman, 645 Fed. Appx. 938, 942 (11th Cir. 2016). CPOs must be registered with the NFA unless the CEO qualifies for an exemption outlined in Part 4 of the CFTC Regulations. See 17 CFR Part 4, §§4.5, 4.7, 4.12, or 4.13(a)(1)-(4). Additionally, the CPO’s principals—broadly defined—and all CPO associated persons (APs), like salespeople, of a CPO must be registered with the NFA.

17 C.F.R. §4.13 contains the three primary CPO registration exemptions: (1) the investment club exemption (17 C.F.R. 4.13(a)(1)) requiring that the manager, to not be required to register with the CFTC, receive compensation, operate only one commodity pool, and no marketing; (2) the small pool exemption (17 C.F.R. 4.13 (a)(2)), applying to CPOs, accepting no more than 15 participants and total gross capital contributions of no more than $400,000; and (3) the de minimis exemption (17 C.F.R. 4.13(a)(3)) requiring that no public marketing interests in the fund, exempt from registration under the Securities Act of 1933, any trading in the fund falls under one of two alternative trading thresholds, the fund accepts only “accredited investors” and other listed investors, and the fund is not marketed for trading in futures, forex, or swap markets. 17 C.F.R. §4.5 contains additional exclusions for otherwise regulated entities, such as investment companies, banks, insurance companies, among others, and employer sponsored benefit plans. If a CPO qualifies for an exemption, the pool operator must electronically file a notice of exemption with the NFA.

A CTA is an individual or organization that, for compensation, advises others as to trading futures contracts or commodity options. See U.S.C. §1a (12)(A). Every commodity pool must have one CPO and one CTA, although the same person or entity may serve in both capacities. In partnerships, the CPO and CTA are the general/managing partner. CTAs may also qualify for an exemption outlined in Part 4 of the CFTC Regulations §§4.6 and 4.14. 17 C.F.R. Part 4 §§4.6, 4.14. If a CTA is exempt from registration as a CTA, then its APs are also exempt. 17 C.F.R. §4.14 contains a wide range of exemptions, provided that any “commodity trading advice is solely incidental to the conducts of its business as,” including many enumerated entities who may have to meet numerous additional requirements. See 15 U.S.C. §§80b-1-80b-2.

Non-exempt CPOs and CTAs Registration Requirements

CPOs and CTAs that do not qualify for an exemption are required to file a completed Form 7-R for the entity and a Form 8-R for each AP/principal

A firm must have at least one affiliated principal to obtain registration under Form 7-R. The application requires extensive background and identifying information. The Form 8-R requires the individual to include similar background and identifying information as well as proficiency requirement disclosures and a fingerprint card.

Individuals applying for registration as a principal or AP must satisfy proficiency requirements. To satisfy such requirements, the principal or AP must pass the Series 3 exam, Series 32 exam, or an alternative: (1) within two years of the date of application; or (2) more than two years prior to the date of application and since that date there has not been a period of two consecutive years when the individual was not registered as an AP or floor broker. An AP solicits orders, customers, or customer funds (or supervises persons so engaged) on behalf of a CPO or CTA. Essentially, an AP is a salesperson or person, who supervises salespersons for a CTA or CPO. Only registered APs can handle customer accounts. Registration is required for any person in the supervisory chain of command, and including a completed online Form 8-R, fingerprint card, and fee, unless the person is already registered with the CFTC.

Post-Registration Requirements

Upon registration, there are a wide range of continuing duties that arise. The following list is by no means exhaustive and each of these issues are fairly nuanced.

CPOs cannot commingle pool funds with other assets. See 17 C.F.R. §4.20. Proper supervision is onerous and requires maintaining compliance procedures manuals, designating a compliance officer responsible for handling customer complaints, and providing APs with training on futures and options. Promotional materials must be maintained for at least five years from the date used and include a statement of risk of loss if they mention the possibility of profit, with past performance results. The registrant must submit any advertisements making specific recommendations to the NFA’s promotional review team and comply with promotional material prohibitions. Account statements must be prepared by a certified public accountant, and must be distributed to pool participants and the NFA within a specified time.

The Use of These Entities in the Hemp Industry

Not surprisingly, these requirements—registration or exemption—require careful consideration. CBD/Hemp companies seeking to engage in futures practices must carefully weigh the potential restrictions.

CBD/Hemp companies have by and large been private ventures closely following regulatory and licensing structures on the state and/or federal level. The futures trading markets would be no exception. Planning to enter this new exchange would likely detract from traditional business operations engaged in by the CBD/Hemp companies. More fundamentally, before any company starts trading in hemp futures, it must make sure hemp is actually being traded.

The Farm Bill of 2018 became law on Dec. 20, 2018. Prior to this law, all non-exempt cannabis plants grown in the United States were scheduled as a controlled substance under the Controlled Substances Act. As a result, the cultivation of hemp for any purpose in the United States without a Schedule I registration with the Drug Enforcement Administration (DEA) was, unless exempted by the Farm Bill of 2014, illegal under federal law.

The passage of the Farm Bill of 2018 materially changed federal laws governing hemp by removing hemp from the Controlled Substances Act, and establishing a federal regulatory framework for hemp cultivation. Specifically, the Farm Bill of 2018: (1) explicitly amended the Controlled Substances Act to exclude from the definition of marijuana all parts of the cannabis plant (including its derivatives, extracts, cannabinoids, isomers, acids, salts, and salts of isomers, whether growing or not) containing a THC concentration of not more than 0.3% on a dry weight basis; (2) allows the commercial production and sale of hemp in interstate commerce; (3) establishes the U.S. Department of Agriculture as the primary federal agency regulating the cultivation of hemp in the United States, while allowing states to adopt their own plans to regulate the same; and (4) affords farmers the opportunity to obtain crop insurance and research grants.

The Farm Bill of 2018 also excluded from the Controlled Substances Act definition of “tetrahydrocannabinol” any material, compound, mixture, or preparation that falls within the definition of hemp. By defining hemp to include its derivatives, extracts, and cannabinoids, popular hemp products, such as hemp-derived CBD, are no longer subject to DEA control. Accordingly, the DEA no longer has regulatory authority to interfere with the interstate commerce of hemp products, so long as the THC level of such products is at or below 0.3%. So this begs the question, how would traders know that they are trading hemp as opposed to high THC cannabis, a federal criminal offense for, among other things, drug trafficking and money laundering, let alone disqualifying the fund from operating.

For one, traders should require the production of a Certificate of Analysis (COA) regarding the hemp or hemp-derived CBD being traded. The COA is prepared by an independent third party testing laboratory, who will chemically analyze the hemp or hemp-derived CBD to ensure the THC content qualifies the product as hemp. Only then will a trader have a reasonable belief it is trading a legal product, as opposed to high THC cannabis.

As such, the CBD/Hemp companies must balance these areas before any decision to engage commodities professionals is undertaken.

Conclusion

With the ever-growing increase in CBD and hemp demand, hemp and CBD businesses may seek to maximize their ability to capitalize on the futures marketplace. CBD and hemp businesses may consider minimizing the need for CFTC and NFA registration, and onerous registration and disclosure requirements if structured correctly.

Reprinted with permission from the July 11 issue of The New York Law Journal. (c) 2022 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.