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In January 2012, NFA and CME Group formed a committee of futures industry self-regulatory organizations (SRO) to examine what changes could be made to rules or to the ways firms demonstrate compliance with those rules to prevent customer losses due to the insolvency of a futures commission merchant (FCM). This SRO Committee included representatives from NFA, CME Group, the InterContinental Exchange, the Kansas City Board of Trade and the Minneapolis Grain Exchange.
In early March, the SRO Committee proposed four initial recommendations for changes to SRO rules and regulatory practices designed to strengthen current safeguards for customer segregated and secured funds.
Included in the recommendations was the requirement of all FCMs to file daily segregation and secured reports, providing SROs with an additional means of monitoring firm compliance with segregation and secured requirements. The reports will also provide another risk management tool to track trends or fluctuations in the amount of customer funds firms are holding and the amount of excess segregated and secured funds maintained by the firms.
The SRO Committee also suggested requiring all FCMs to file Segregation Investment Detail Reports (SIDR), which detail how customer segregated and secured funds are invested and where those funds are held. These reports would be filed bimonthly, which will enhance monitoring of how FCMs are investing customer segregated and secured funds.
Another recommendation would require DSROs to perform more frequent periodic spot checks to monitor FCM compliance with segregation and secured requirements. Currently, FCMs are audited each year by both their DSRO and their outside accountant. The periodic spot checks would be in addition to the routine annual audits.
The fourth recommendation would require a principal of the FCM to approve in writing any disbursement of customer segregated and secured funds not made for the benefit of customers and that exceed 25% of the firm's excess segregated or secured funds. The firm would also be required to provide immediate notice to its SROs. This recommendation has subsequently been referred to in the media as the "Corzine Rule", named after MF Global's former CEO John Corzine.
Dan Roth, president of NFA, stated that "The committee believes that these recommendations will provide regulators with better tools to monitor firms for compliance with segregation and secured requirements and strengthen the industry's customer protection regime. These are our initial recommendations. We will continue to work with the CFTC and the industry as we consider additional improvements."
Roth also stated that some of the SRO Committee's recommendations would be implemented shortly; while others require rulemaking. NFA expects to present rule proposals implementing these changes at the next Board meeting, scheduled for May 17, 2012.
NFA has participated in various panel discussions to educate representatives in Washington about the SRO Committee's initial recommendations. Roth appeared in front of the House Financial Services Oversight and Investigations subcommittee earlier this year to outline the suggested regulatory enhancements. (See testimony.) He also participated in a roundtable organized by the staff of the U.S. Senate Committee on Agriculture, Nutrition and Forestry to discuss the recommendations made by the SRO Committee and to explore other ways the industry, SROs, the CFTC and Congress can better protect customer funds.
In February 2012, the CFTC amended Part 4 of the Commission's regulations involving the registration and compliance obligations for commodity pool operators (CPOs) and commodity trading advisors (CTAs). The CFTC adopted amendments to Regulation 4.5 that were in response to NFA's August 2010 Petition for Rulemaking that highlighted NFA's customer protection concerns with SEC registered investment companies (RICs) offering managed futures strategies. The CFTC also rescinded Regulation 4.12(a)(4) - a broadly held exemption from CPO membership in place since 2003. The elimination of these exemptions could significantly increase the number of NFA CPO Members.
Amendments to CFTC Regulation 4.5
CFTC Regulation 4.5 makes available to certain eligible persons, including RICs, an exclusion from the definition of CPO with respect to their operation of certain entities that would otherwise be considered commodity pools. NFA became aware of a number of RICs (i.e., mutual funds) that offer actively managed futures strategies. These mutual funds, which are offered and marketed as commodity futures investments to the retail public with low initial investments, claimed the CFTC Regulation 4.5 exclusion and therefore were not subject to the CFTC's jurisdiction and NFA oversight.
"In August of 2010, NFA submitted a proposed petition for rulemaking to the CFTC that would re-impose operating restrictions that were in place prior to 2003 on a RIC. A RIC claiming the 4.5 exclusion would be required to represent that the fund would not be marketed as a commodity fund and would limit its futures trading activities," said Tom Sexton, NFA's general counsel.
In January 2011, the CFTC published proposed changes to Regulation 4.5. In order to effectively respond to the Commission's request for input, NFA assembled an informal working group of industry participants that operate public commodity pools, RICs trading commodity interests and private counsel who specialize in both the CFTC's Part 4 Regulations and the Investment Company Act of 1940. The working group helped NFA draft a comment letter related to the proposed rulemaking and considered a number of issues related to rule harmonization for RICs under a dual CFTC/SEC regulatory regime.
In February 2012, the Commission approved proposed amendments to Regulation 4.5 that re-impose the pre-2003 trading and marketing restrictions on RICs claiming an exclusion from CPO registration pursuant to Regulation 4.5. The Commission recognized that the reinstatement of these operating restrictions will require the investment advisers of certain RICs participating in the derivatives markets to register as CPOs, which could increase the number of NFA Member CPOs.
NFA and many industry participants raised concerns about the potential conflicts between the CFTC's regulatory regime and that imposed by the SEC if the Commission were to amend Regulation 4.5 to require certain RICs to be regulated as commodity pools. The Commission recognized that it is necessary to harmonize its Part 4 compliance obligations with the SEC's requirements applicable to RICs. Therefore, concurrently with finalizing the amendments to Regulation 4.5, the Commission also issued a proposed rulemaking detailing amendments to Part 4 to harmonize the compliance obligations that will apply to dually registered IAs.
The Commission's proposal had a sixty-day comment period. NFA met with the Committee assembled last year to assist NFA with the issues related to the 4.5 proposal and received its input regarding the CFTC's harmonization proposal. NFA submitted its comment letter on April 24, 2012.
The Commission stated that compliance with Regulation 4.5 for registration purposes only shall be required not later than the later of December 31, 2012 or sixty days after the effective date of the final rulemaking further defining the term "swap". Entities required to register due to the amendments to Regulation 4.5 shall be subject to the Commission's harmonized Part 4 requirements relating to recordkeeping, reporting, and disclosure within sixty days following the effectiveness of the Commission's final rule completing harmonization.
Amendments to CFTC Regulation 4.13
The Commission has also rescinded a widely-held exemption from CPO registration-Regulation 4.13(a)(4). The rule's exemption was available to persons offering a pool whose participants are QEPs only. The Commission determined to rescind it because there are no limits on the amount of commodity interest trading in which pools operating under this exemption can engage.
The Commission's elimination of this exemption is also expected to increase the number of CPO registrants and NFA Members. The Commission set a compliance date of December 31, 2012 for CPOs currently claiming an exemption under Regulation 4.13(a)(4) to register and be in compliance with applicable Commission regulations.
For more information about the amended regulations, please visit the CFTC's website.
NFA's Business Conduct Committee has issued nearly 400 complaints against Member firms and individuals for various rule violations in the past ten years. The majority of those cases are handled solely by NFA; however, there are some instances where violations are so serious that NFA has referred them to other regulatory organizations and law enforcement agencies.
From scammed investors that tip NFA off to independent investigations leading to questionable website material, this second article, in a two-part series, looks at cases where NFA has worked with the Commodity Futures Trading Commission as well as other regulatory organizations and enforcement authorities to catch criminals and improve the safety and soundness of our markets.
Lake Shore Asset Management LTD
Lake Shore Asset Management LTD was a commodity pool operator (CPO) and commodity trading advisor (CTA) Member of NFA since January 2007. The firm was headquartered in Hamilton, Bermuda and Philip J. Baker was a principal and general partner.
NFA received a referral from the CFTC regarding information included on Lake Shore's website and immediately commenced a review of the firm's operations.
"The CFTC had been looking at Lake Shore's website and had concerns about the rates of return that were reported. They were significantly high," said Ronald Hirst, associate general counsel. "So the CFTC asked us to look into the matter."
After reviewing the website, NFA found that it promoted the firm as operating a number of pools and managing customer accounts. A press release included on the site touted a 13 year performance history for Lake Shore's "flagship" program of 19.53% compounded annual return. NFA auditors requested information and documents from Lake Shore to verify the nature of Lake Shore’s business, including the identities of its customers and pool participants, the value of their investments, the amount and location of assets under management, and the accuracy of performance information featured on Lake Shore’s website. However, Lake Shore refused to cooperate with NFA and failed to provide the information and documents requested by NFA. Therefore, NFA issued a Member Responsibility Act (MRA) against Lake Shore in June 2007 which prohibited the firm from soliciting or accepting any customer or pool participant funds, placing trades except for the liquidation, and disbursing any funds from any accounts without prior approval of NFA.
NFA issued an amended MRA in August 2007 after determining that Lake Shore's website was fraudulent because it featured positive rates of return for its pools when in fact the pools had lost approximately $29 million. The amended MRA suspended Lakes Shore's NFA membership.
Collaborating together, NFA and the CFTC developed evidence of several additional serious violations by Lake Shore, Baker and other unregistered individuals and entities related to the firm. The CFTC filed a complaint against Baker for violating the Commodity Exchange Act and CFTC regulations. In addition to working with the CFTC, NFA shared information with the Chicago offices of the FBI, the U.S. Attorney's office and the U.S. Postal Inspectors regarding this case. In February 2009, Baker was indicted for his role in defrauding hundreds of investors out of millions.
After extradition from Hamburg, Germany, Baker pleaded guilty to one count of wire fraud in a Chicago federal court in August 2011 to a scheme that cost 900 investors a total of $294 million. On November 17, 2011, he was sentenced to 20 years in prison, the maximum allowed.
V-Tek Trading Group
V-Tek had been a CTA Member firm since January 2000 and was located in Chicago, Illinois. NFA records showed that its principal was Edward Velazquez.
During an audit of the firm, NFA noticed discrepancies related to a trading program called EVO Trading. NFA reviewed the October 2003 disclosure documents but could not verify the accuracy of its performance claims. NFA was persistent in following up for further documentation but Velazquez did not provide supporting materials.
According to NFA's records, the EVO Trading program managed about 40 accounts; however, account information provided by V-Tek did not match up to a spreadsheet the firm prepared with lists of customer accounts and rates of return. Other discrepancies included commissions and fees charged to customers that were reflected on carrying broker statements but did not match up with the records V-Tek kept and provided.
"V-Tek also failed to produce customer agreements documenting the nominal value of accounts, the size of the account being traded, which is required information to test the performance data in the EVO trading program," said Hirst.
In November 2004, NFA issued a complaint against V-Tek and Velazquez alleging that the firm and its principal failed to cooperate with NFA. The complaint also charged V-Tek with using deficient disclosure documents for its investment program, called EVO Trading, which it marketed to customers.
Concurrent with NFA's action, the CFTC filed an injunction in U.S. District Court freezing the assets of V-Tek and Velazquez.
In 2005, Velazquez and V-Tek Trading Group submitted an offer of settlement to NFA agreeing to permanently withdraw as NFA Members.
In 2008, the CFTC issued a consent order settling its fraud charges against V-Tek and Velazquez. The consent order barred both from engaging in futures trading and ordered V-Tek and Velazquez to pay $6.7 million in restitution and a $4.9 million fine. The court found that the defendants misappropriated customer funds and made material misrepresentations and gave false and deceptive statements to customers.
A year later, a federal grand jury in Chicago indicted Velazquez and charged him with misappropriating customer funds and making materially false representations to customers regarding his background. He jumped bail in December 2009 and became a fugitive for six months, until he was taken into custody in June 2010. In February 2011, he pleaded guilty to the federal criminal charges and is scheduled to be sentenced on June 28, 2012.
These two cases demonstrate NFA's ability to identify manipulative market participants and collaborate efficiently with other regulatory agencies to best protect the futures markets.
In a final related note, it was previously reported in the January 2012 Member Newsletter that Charles Martin and John Walsh, affiliates of One World Capital Group LLC, were awaiting sentencing for defrauding 1,000 investors in a Ponzi-type scheme. Since the article was published, Martin was sentenced to 17 years behind bars and Walsh got a 12 year sentence.
The following actions were taken by NFA's Board of Directors at its meeting on February 16, 2012.
The Board elected Christopher K. Hehmeyer, non-executive chairman at Penson Futures, to a one-year term as chairman and Paul J. Georgy, president of Allendale, Inc., to a one-year term as vice-chairman.
The Board approved an amendment to NFA Financial Requirements Section 14, eliminating the references to "U.S. customers" related to the amount owed by FDMs/RFEDs to retail forex customers and held at one or more qualifying institutions. Financial Requirements Section 14 imposes this requirement with respect to U.S. customers, while CFTC Regulation 5.8 applies to all retail customers. In order to keep NFA's requirements consistent with those of the CFTC, the board approved the amendment and removed the reference to "U.S. customers."
The Board approved amendments to Interpretive Notice 9053 - Forex Transactions deleting references to "credit ratings". The Notice currently indicates that an FDM may not include assets held by an affiliate or an unregulated person in the firm's current assets and may not use these entities to cover forex transactions for purposes of determining it's adjusted net capital, unless the affiliate or unregulated person has been approved by NFA. The Notice lists "a person's credit rating" as a factor NFA may consider in determining whether to approve an FDM's affiliate or an otherwise unregulated person for these purposes. The Board's deletion of "credit ratings" from the Notice was done to keep NFA's Notices consistent with the CFTC's recent action to delete any references to or reliance on ratings from its regulations.
The Board approved amendments to NFA's Interpretive Notice 9058 related to NFA Compliance Rule 2-40: Procedures for the Bulk Assignment or Liquidation of Forex Positions; Cessation of Customer Business. The amendments clarified the reporting responsibilities for an assignor/transferor FDM and an assignee/transferee FDM to make it clear that the assignee/transferee FDM must provide NFA with certain information immediately after a bulk assignment, liquidation or transfer.
The Board approved the following committee appointments:
Appeals Committee: Jeffrey C. Borchardt, George E. Crapple, Michael C. Dawley, William McCoy and Susan M. Phillips.
Membership Committee: Scott A. Cordes, Silas Keehn and Ronald S. Oppenheimer
Business Conduct Committee: Dorothy E. Bossung, Thomas L. Casey, Clarence Delbridge, III, Frank A. Gelber, Eric S. Wolff and William Gerlesits.
FCM Advisory Committee: David M. Battan, Donald R. Levine, Bonnie Litt and Russell R. Wassendorf.
CPO/CTA Advisory Committee: Robert J. Amedeo, Barbara A. Pfendler, Gerard G. Trevino, Michael P. Dever and Craig L. Caudle
IB Advisory Committee: Stephen D. Reece, Richard C. Schlabs, Michael T. Sherzan, Scott W. Stewart and Sam Peterson
Hearing Committee: Carlton Anderson, Terrence B. Clarke, Timothy P. Daven, Patricia C. Donahue, Carl W. Gilmore, John C. Jensen, Lawrence O. Kaplan, Eric L. Kunkes, Timothy J. Lankford, Timothy E. McDermott, Natalie McNeely Peters, Joy Pava Schulruff, Richard W. Petticrew, Mark J. Powers, Wendy Robinson, Mary Beth Rooney, Carmen D. Soldato, Scott W. Stewart, John D. Streich, Michael A. Turro, Jan R. Waye, Calogero B. Carcione and Ronney Lynne Rosenberg.
Discretionary Account Waiver Panel: Patricia C. Donahue
NFA discusses the U.S. regulatory framework at the 15th Annual Association of Futures Markets
The Association of Futures Markets (AFM) held their annual conference in Budapest, Hungary from March 7-9, 2012. NFA participated in the Pre-Conference Workshop on March 7 on regulations and surveillance. Ed Dasso, vice president of Market Regulation, and Karen Wuertz, senior vice president of Strategic Planning and Communications, participated via teleconference from NFA's Chicago office and discussed the U.S. regulatory framework, core principles for contract markets and market surveillance. The conference also covered topics such as high frequency trading, exchange connectivity, lessons learned from MF Global and a derivatives markets outlook. For more information about the AFM, please visit their website.
NFA provides guidance on swap registration requirements
On January 11, 2012, the CFTC finalized rules that require all swap dealers (SDs) and major swap participants (MSPs) to register with the Commission and become a member of a registered futures association. NFA's OTC Department has participated in seminars sponsored by law firms such as Allen & Overy, Davis Polk and Cadwalader to answer questions from their clients related to swap registration requirements. NFA will continue to participate in industry efforts to field questions from potential SDs and MSPs.
NFA participates in the NIBA Sales and Marketing Conference
The National Introducing Brokers Association (NIBA) held a Sales and Marketing Conference in New York on Wednesday, April 18, 2012. NFA's Associate Director of Audit Management and Education Patricia Cushing, participated in NIBA's Semi-Annual Legal Review discussion and addressed NFA's response to Dodd-Frank and NFA's recommendations for regulatory changes in light of MF Global. Besides a CFTC update from Kevin Piccoli, director of Division of Swaps and Intermediary Oversight at the Commission, the agenda also focused on the risks of doing business with your FCM, how to better protect customers and forex related issues. If you are interested in learning more, please visit the conference homepage.
NFA participates FIA's Law & Compliance Conference
Several NFA senior staff members will be panelists at various sessions at the FIA's annual Law & Compliance Conference in Baltimore, Maryland from May 9-11, 2012.
NFA's Executive Vice President and Chief Operating Officer Dan Driscoll and General Counsel Tom Sexton will participate in the "Soup to Nuts" discussion scheduled for Wednesday, May 9. The panelists will look at the Commodity Exchange Act, including Title VII of the Dodd-Frank Act and the execution and clearance of exchange and SEF-traded derivatives.
On Thursday, May 10, NFA's Vice President of Market Regulation Ed Dasso will be a panelist at the "Exchange and SEF Update" session focusing on governance, registration and outsourcing regulatory services to NFA. Also on Thursday, NFA's Senior Vice President of Compliance Regina Thoele will participate in the "Litigation and Enforcement Update" session addressing CFTC and SRO enforcement programs and actions, the CFTC's new anti-fraud and anti-manipulative rules and developments in the MF Global and Sentinel bankruptcy proceedings. Finally, on Thursday, NFA's Associate General Counsel Carol Wooding will be a panelist at the "The Role of the Compliance Officer and Internal Controls in the New World" session discussing the responsibilities of the chief compliance officer and the compliance staff as well as how to run a successful compliance program.
On Friday, May 11, Mary McHenry, NFA's senior manager of Compliance, will participate on the "Asset Management Development" panel examining regulatory initiatives applicable to the asset management community.
To learn more about this conference, please visit the conference homepage.
NFA and partners work to bring awareness to financial literacy and education during Money Smart Week
NFA is one of many partner organizations to come together in an effort to coordinate Money Smart Week Chicago (MSW) which took place April 21-28, 2012. The initiative, led by the Federal Reserve Bank of Chicago, offered free classes, seminars and activities promoting financial literacy and education. As part of MSW, NFA participated in the Financial Regulator's Fair on Wednesday, April 25, and co-sponsored a seminar with AARP and the CFTC titled, "Avoiding Fraud is Your Best Money Strategy" on Thursday, April 26. Finally, NFA worked with the Chicago Board Options Exchange (CBOE) on a presentation focused on introducing the basics of trading futures and options and avoiding investment fraud on Friday, April 27. If you are interested in learning more about Money Smart Week, please visit the Money Smart Week website.
NFA speaks on MFA panel focused on recent CPO registration requirements
The Managed Funds Association (MFA) is holding their 18th annual Forum 2012 in Chicago on June 12-13, 2012. The program aims to bring institutional investors together with CTAs and global macro managers to discuss strategies, opportunities and business development. The agenda will also spotlight the current legislative and regulatory issues impacting the alternative investment industry including the amendments to CFTC Regulation 4.5. NFA will be participating on a regulatory compliance panel scheduled for Tuesday afternoon, June 12th. If you are interested in learning more about this conference, please visit the MFA website.