by Bart Mallon, Esq. of Cole-Frieman & Mallon LLP
On March 2, 2010 the NFA held an all-day seminar at the UBS Conference Center in Chicago for the futures and commodities communities. With limited exceptions, the seminar provided useful information and allowed the audience to interact with the regulators directly through Q&A opportunities or by networking during the break periods. This overview will provide a quick summary of the major items discussed and the notes I took during the day. Full supporting materials for each session have been posted on the NFA’s website and the NFA will provide an audio CD of the seminar upon request.
Session One: The Current State of CPO/CTA Regulation
This session may have been mis-named as it focused solely on the potential changes with respect to the broader financial system. Accordingly, much attention was (needlessly) focused on some of the proposed bills pending in the House and Senate (which may or may not ever become law). After discussing the proposed bills in general, the panel moved to the proposed legislation with respect to the OTC derivatives markets (see CFTC thoughts on OTC derivatives regulation and Chairman Gensler’s Recent OTC regulation remarks). Brief mention was also made regarding the CFTC proposal to limit energy positions. A large part of the session was also devoted to issues dealing with harmonization between the CFTC and the SEC, which naturally included a discussion of the OTC derivites markets.
What did any of this have to do with CPO/CTA regulation as the title of the seminar indicates?
Not a lot, but the session did give the NFA a chance to frame some of the issues for the day and show that the mandate of the CFTC and NFA is broad. Surprisingly, the panel did not even mention one of the major proposed regulations which would affect a large number of CPOs/CTAs (and bring many more firms under the CFTC’s jurisdiction) – that issue was the proposed retail forex regulations.
When the panel was asked about the proposed forex regulations the NFA’s Dan Driscol mentioned a couple of interesting things. First, the NFA has been proceeding under the assumption that the forex registration rules will pass and that a large number of forex managers will need to be registered with the CFTC. Accorindingly, the NFA has been building out its systems and apparently there is some sort of way for the NFA to earmark which firms are forex firms (perhaps for greater oversight). The NFA also believes that during the registration process there is going to be a lot of hand holding, but also a lot of enforecment actions.
With respect other parts of the proposal, especially with respect to the increased margin requirements (100:1 leverage will move to 10:1 leverage under the proposed regulations), the NFA indicated that it will be providing the CFTC with a comment letter addressing its thoughts (see NFA Indicates Support for Greater Leverage). Specifically the NFA indicated that they believe margin requirements should be based on the volatility of the underlying instrument (here, the major currencies). While the NFA is not going to take a hard stance, the NFA is expected to provide the CFTC with more information on its experiences with respect to the margin requirements. The comment period for the retail forex proposal ends on March 22 so we will report on the NFA’s comments when they are available. [Note: Cole-Frieman & Mallon LLP will be providing comments on the proposed rules.]
Session Two: Disclosure Document and Performance Reporting
As all CTAs and CPOs probably have experienced, having a disclosure document reviewed and approved by the NFA can be an aggravating experience. Notwithstanding my own opinions on this issue, the panel started by discusing the 4.13 exemptions. The panel noted that the CFTC’s Part 4 regulations require very specific items from disclosure documents. Generally most CTAs and CPOs are familiar with the more important parts – risk disclosures and risk factors, conflict of interests and fee information.
The lawyer on the panel made the case for overdisclosure – the framework which managers should use when thinking about the disclosure documents is that of an opposing counsel in the future. In the event that something would go wrong in the future, what in your disclosure documents would opposing counsel point to? Is there anything which you would be embarrassed about if it was brought before the jury? Is there anything that is simply misstated or omitted? These are the types of things that opposing lawyers would point to during a lawsuit and therefor all managers (whether registered or not) should always make sure anything they give to investors is accurate and discloses all material information.
The panel began in earnest by talking about common comments on disclosure documents.
Common comments
- Forex. Under principal risk factors many forex managers have risk factors which have been modified from futures disclosure documents. However, the futures and forex industries operate different therefore there is not the issue with clearing. Also forex transactions are structured different than for futures transactions and therefore the cost structure is different. [New NFA Rule 2-41. Forex risk disclosure statement needs to be exactly as stated in the rule.]
- Litigation statement. The litigiation needs to be up to date. Many FCMs will continually update their litigation disclosure statement and if the most recent statement is not in the disclosure documents the NFA will check and will let you know in the deficiency letter that it needs to be updated.
- Bios/manager background. It is a requirement for the managers bios to be included and the manager must include the dates of all employment (including unemployment or schooling) for the preceeding five years. This means both month and date needs to be included. Managers need to make sure the dates in the bio match with the dates in the Form 8R.
Litigation Statements
CTAs and CPOs are required to provide the litigation history for the firm and, more importantly, for the FCM and IB. These litigation disclosures are dense paragraphs of legalese which is designed to inform the investor of the potential legal issues with the FCM or IB. In practice these disclosures end up being pages long and, in my experience, are practically unreadable which brings up the question of their utility and if such disclosures really protect investors.
Notwithstanding the above, it is a requirement and CTAs and CPOs need to make sure that the ligitation statement is complete, accurate and up to date. Firms should also realize that the litigation statement may change during the review process which is what happened recently to one of my clients. The disclosure document received no comments from NFA staff except that the litigation statement for the firm’s FCM had just changed days earlier and would need to be updated. This needlessly added weeks to client’s start date.
CTA and CPO Documents “Not Boilerplate”
The attorney on the panel stressed that disclosure documents are not boilerplate, no matter how similar they may appear. He went on to note that there is a lot of detail in the documents and that it is essentially a manager’s contract with the investors. He stressed that managers should know and understand every detail of their documents. I completely agree.
One of the employees of a large CFTC registered firm noted that the manager needs to make sure that the disclosure document accurately reflects the way that business is conducted in the firm. Managers should ask operational personnel to review the document to make sure the language captures the manner in which the firm operates – if there are discrepencies between the document and operational procedures, the document should be amended or revised.
Performance Capsules
There are a number of issues which arise in the context of performance capsules and therefore a firm must take care to make sure that the capsule mirrors the NFA requirements exactly.
Break-Even Analysis
Every CTA or CPO disclosure document needs to include a break-even analysis. Generally this analysis will show a prospective investor or client the amount of gains necessary in order to break-even on the investment. Naturally the break-even analysis is an inexact science and, therefore, it is arguably of little value. For instance, the numbers in the table (at least for a newly registered CTA or CPO) are based on assumptions with respect to both level of assets as well as expected trading volume.
While there was no single or common issue discussed with regard to the break-even analysis, the NFA noted that for those managers which allocate or invest in underlying CTAs or CPOs, then the break-even analysis would also need to include the incentive fees payable at the underlying level. The NFA went through the calculations involved with determining such expense.
Timing and Section 4.8
During the question and answer period, I asked the panel whether they often times see groups using the CFTC Regulation 4.8 exemption during the approval process. I think that literally two or three of the representatives from the NFA said that they did not know what Regulation 4.8 was – I noticed that the attorney on the panel might have something to say and so I asked him if his clients had used it. He explained Regulation 4.8 and noted that he did not recommend clients use it because it is awkward to go back to pool investors and explain the issue.
The NFA took the opportunity to say that managers should allow plenty of time to go through the registration process.
Session Three: Pool Financial Reporting
There were essentially two parts to this presentation: a discussion of the new reporting requirements for the NFA and a discussion on fair value and derivatives.
For the first part, Tracey Hunt of the NFA provided information on some of the new reporting changes for CFTC registered firms. These include issues devoted to series funds, relaxed rules regarding liquidation statements, an extension for fund of fund filers.
Perhaps more importantly for many of the groups at the conference was the discussion of new NFA Rule 2-46 and a presentation of the reporting systems for the rule. Rule 2-46 essentially requires certain operators who have reporting requirements under CFTC Regulation 4.22 to make a quarterly filing through the NFA’s EasyFile system. CPOs will need to provide the NFA with the following information within 45 days of the end of the calendar quarter:
- Key Relationships – pool administrators, carrying brokers, trading managers, custodians
- Statement of Changes in NAV
- Monthly Rates of Return
- Schedule of Investments – all pool investments greater than 10% of fund NAV need to be disclosed (even if the positions are not futures/commodities)
We were provided with screen shots of the new filing system and it seemed both robust and complicated. The NFA has noted that they have spent a lot of time to update their EasyFile system to accomodate the filers. Even so, we believe their are likely to be bugs in the system and so we recommend that groups begin the EasyFile system as soon as possible to avoid missing the deadline because of technical issues. The system will have functionality to allow for many of the fields to populate automatically based on previous submissions. There are also some specialized issues with respect to master-feeder and fund of fund structures – generally the system will require you to keep drilling down until you reach the actual investments, no matter how many organizational layers are in the structure.
The second part of the discussion included a powerpoint slide from Deloitte discussing new issues with financial reporting. Essentially differences between level 2 and level 3 assets.
Keynote Speech from CFTC Commissioner Dunn
During lunch, which was actually quite nice, CFTC Commissioner Dunn delivered the keynote speech. As all speakers from government agencies do, he noted that his comments were his own and not of the CFTC. He spoke generally about the challenges facing the CFTC and that the issues are more complex than the issues the CFTC had to deal with in the past. Additionally, with greater financial regulation looming, the CFTC’s job (in conjunction with the SEC in certain circumstances) has become even more important.
He also talked to varying degrees on the following issues:
- The historic two day meeting between the SEC and the CFTC regarding harmonization
- A potential uniform fiduciary duty for all investment advisers (or other groups under SEC and CFTC jurisdiction)
- Potential future regulation of the OTC derivitatives markets – he noted his support of OTC derivitatives regulation and Chairman Gensler. He did note, however, that there are many issues that would need to be worked out with any proposed legislation or regulation. He also discussed the proposed position limits on certain energy contracts.
- Retail forex and the large amount of comments which have been received.
Session Four: Sales Practices
Perhaps the most entertaining of the panel discussions was on sales practices. The discussion was led by John J. Lothian who is well-known in the futures industry and created MarketsWiki. John did a fantastic job of including all of the panelists which included Natalie Peters of DigiLog Capital LLC, and Dorothy Bobak and Alexandra Shipovskikh, both from the NFA.
Common Deficiencies
The NFA discussed the following common deficiencies:
- websites often have many deficiencies including with the general disclaimer and ommissions – it was stressed that the Member must be able to support all material statements of fact on the webiste
- opinions should be clearly labeled as such
- past trading performance will generllay have a lot of issues
- general issue with stuff on third party websites – if you see something that is not correct, even if you did not place it there, you should ask the webmaster to revise or take it down. a member may have some oversight responsibilities
Links from a Member’s Website
Generally a firm should have superviosry procedures in place for linking from a proprietary website to another unaffiliated website (note: Cole-Frieman & Mallon LLP generally recommends to clients that they do not link out to unrelated websites)
- Members should make sure that outbound links adhere to requirements of NFA Rule 2-9 and NFA Rule 2-29
- Member need to monitor outbound links through periodic review
- With respect to reporting sites (i.e. AutumGold, Barclays) you need to make sure all of the information is accurate and all descriptions of the pool or trading program are complete.
Social Media
The NFA just recently amended Rule 2-29(h) and released a social media interpretive notice. The new notice solidifies many of the principles of 2-9 and 2-29 but also deals with specific issues with sites like YouTube, Twitter, LinkedIn, Facebook, blogs, etc. Interestingly, the NFA announced that it has a Facebook page which is used for recruiting new staff members.
With respect to the new rule and different media, the following was discussed:
- Twitter. How do you comply with 2-29 (disclaimer rule) within 140 characters? The media is necessarily different than a trditional website with a disclaimer. One way might be to format your Twitter page with a prominent disclaimer. You will need to make sure that all of the material you tweet is balanced pursuant to the promotional materials rule. There is always a potential problem with re-tweets. With respect to re-tweets, a Member may have an affirmative duty to ask another person to take down the re-tweet (which request itself, presumably, would be subject to record keeping requirements). Suggestion: use software to complie an archive of tweets. If you remove a tweet, you still need to keep a record of that tweet. The software should be able to provide a record of this. A firm should have a policy regard re-tweets (both by the Member or of the Member’s content).
- Facebook. Many groups have a Facebook page. The question was whether a simple Facebook page with basic information would constitute “promotional material” – the NFA said maybe. The next question would be whether the firm was “soliciting” by having a Facebook page. Suggestion: a firm should institute the same oversight policies and procedures for a Facebook page as they would for other promotional materials.
- YouTube. As both an audio and a video platform, a YouTube video will generally be subject to NFA Rule 2-29(h). Generally this will require that any audio or video advertisement be submitted to the NFA prior to use. If a member has something that was on YouTube prior to Febuary 1 then the member should take it down immediately and submit the media to the NFA for review – this material is not grandfathered into the amended rule. It sounded like the NFA will be looking at YouTube in the future to catch violations.
- Other Mediums. Podcasts, blogs, forums, public wikis, and other forms of media all have medium specific issues which managers should discuss with counsel prior to displaying material which might be considered promotional material.
A firm which uses any of the mediums described above should have policies regarding education of employees on rules and responsibilities and appropriate oversight of the employees. If you firm needs to implement such policies and procedures, Cole-Frieman & Mallon LLP can provide guidance.
How to submit materials
In the event that a firm is subject to Rule 2-29(h) and therefore required to pre-file advertising materials, those materials can be submitted to the NFA in any format including CD, email, zip files, etc. In the context of live feeds, webinars, and seminars – the Member firm should submit an outline of what will be discussed prior to the live performance then submit an recording of the performance after it has happened. Such procedures are generally what you would do if an associated person or principal appeared on live television like CNBC or Bloomberg TV.
Session Five: The NFA Audit Process
Maybe one of the most important things that a firm should be ready for is an NFA audit. For many firms this is a painful process which causes anxiety, but for other firms, it might be an opportunity to get an outside review of back end business operations for “free.” Regardless of how a group views an audit, the discussion was helpful in identifying areas where managers can focus their attention in order to make the audit go as quickly as possible.
Who gets audited by the NFA?
There are no good answer with respect to when a member firm may expect to be audited by the NFA. In general FCMs and very large managers are likely to face NFA audits on a more regular basis. Forex firms can also expect to be audited more regularly than traditional futures only firms. Traditional CTAs and CPOs are under no timeline requirement so these groups might not see an audit for up to three years or longer.
Audit Process
Generally the NFA will alert a member firm 2-3 weeks prior to the exam. This gives the firm plenty of time to gether the inital records and other items requested by the NFA prior to their arrival. While the amount of information requested might seem to be enormous, a firm should attempt to comply with each item as this will decrease the amount of time the NFA will spend at your place of business.
The actual audit may take place over a day or be 2-3 days long. Larger firms can expect the NFA to be on site for a week or longer. The amount of time obviously depends on a number of factors including the size of the member firm and complexity of operations. During the audit there will likely be a lot of interaction between the compliance officer and the auditor. At the end of the audit they will provide the firm with a request list.
One of the most important items to keep in mind during the process is to keep open communication with the auditor. If you believe that the NFA findings are incorrect, you should discuss the issue with the auditor – at times they may see your point of view and side with you.
NFA Self-Exam Checklist
The most import item for Member firms to complete on yearly basis is their annual self-exam. Cole-Frieman & Mallon LLP has provided easy to use NFA self-examination checklists. Generally firms will need to take time to complete these lists on an annual basis and will need to keep a record of these actions pursuant to the firm’s recordkeeping policies.
Focus Areas
- General. General issues which often are reviewed include proper registration, review of promotional material, performance reporting, trading (make sure recommendations appropriate), supervision, etc.
- Valuation. If there are level 2 or level 3 assets there is likely to be greater review; principals need to make sure they sign off on level 2 or level 3 valuations.
- Side Letters. This is a new focus area and the focus here will be to make sure the manager is doing what he says he will do in the side letter
- Side pockets. Valuation of assets is going to be a focus area.
Common Audit Deficiencies
- Promotional material. Issues include ridiculous performance numbers, withholding information from previous accounts, inaccurate numbers, etc.
- Bylaw 1101. Requires that, as a NFA Member Firm, you only do business with other NFA Member Firms or firms that do not need to be registered; firms should have procedures in place to make sure other firms are either registered or not required to be registered (especially in the fund of funds context).
- Inconsistencies. Your disclosure documents and compliance manual/ policies and procedures should be an accurate reflection of your firm’s actual operations.
- Bunched orders. If a CTA firm bunches client orders, the CTA must conduct a quarterly review to make sure allocations to client accounts are done in a non-preferential manner.
- NFA Rule 2-45. No loans from the pool to the manager for own personal use (ex. manager taking money out of pool to pay off mortgage)
Other items
- Firms should remember that they need to distribute a privacy policy to customers on a yearly basis (perhaps send it out with December statement).
- Disaster recovery plan (DRP) should be reviewed at least annually. The DRP should be resonable based on operations. This is an area where the auditors do not pay as much attention to.
- Firm need to have ethics training procedures. Many of these procedures are boilerplate. Firms should make sure they follow their internal procedures.
- Creating folders, filing and other systems on the front end will help the firm to remain organized and will help to keep the audit moving as quickly as possible.
Future Seminars
If you are interested in other seminars and conferences, I recommend the New York CTA Expo on April 21 which Cole-Frieman & Mallon LLP is sponsoring. Also, the NFA is having another CPO/CTA conference in New York on April 22. If you are in the San Francisco Bay area, we would also like to extend an invitation to the San Francisco Futures Professionals group which meets every couple of months to discuss issues relevant to members.
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Cole-Frieman & Mallon LLP (www.colefrieman.com) provides comprehensive legal and compliance services to commodity trading advisors and pool operators. You can reach Bart Mallon, Esq. directly at 415-868-5345.