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Correcting common regulatory deficiencies

NFA conducts approximately 800 audits of Member firms every year, and while the overwhelming majority of the audits result only in minor (if any) violations, we have frequently noticed certain types of regulatory deficiencies repeated at several different firms. To help you meet your regulatory responsibilities as efficiently as possible, we have compiled a list of the most common deficiencies we have found while conducting our audits. In the paragraphs that follow, we will describe a few of them as well as discuss ways to correct them and avoid similar errors in the future.

Registration
During an audit, we review the firm's registration records and employee activities to ensure that firm employees are properly registered. Employees that are soliciting customers and making trading recommendations are generally required to be registered as Associated Persons. Additionally, all individuals and entities that have a controlling influence over the firm's operations, such as an officer or director, or own greater than 10% of the entity, are required to be registered as a Principal of the firm.

We also review the firm's activities to ensure that our Members are conducting business only with NFA Members and CFTC-registered individuals and/or entities, as required by NFA Bylaw 1101.

As an NFA Member, you should have procedures in place to conduct appropriate due diligence to ensure that you are in compliance with Bylaw 1101 and all other registration requirements. This should include reviewing all futures accounts, all futures professionals employed by your firm and all entities conducting futures-related business with your firm.

There are two convenient methods of determining if an entity or individual is registered and an NFA Member. You can access NFA's Background Affiliation Status Information Center (BASIC) through our Web site at www.nfa.futures.org, or you can call NFA's Information Center at (800) 621-3570.

If a firm has no current registration, you should request a written representation from the entity or individual, indicating their primary business and why they are not required to be registered and an NFA Member. You should also make sure the representation appears adequate based on the information you know about the entity or individual. If you still have any questions about the firm or need additional guidance, call NFA's Compliance Department.

Finally, you should maintain written documentation of the steps you have taken as part of your due diligence. We recommend that you conduct this due diligence at the commencement of the relationship and on an ongoing basis.

Promotional Material
Promotional material is an important part of marketing your business, and we have developed a regulatory guide devoted exclusively to helping you understand your regulatory responsibilities in this area. However, we continue to see some deficiencies in promotional material, particularly related to disclaimers and unsupported statements.

For example, we have seen that some firms do not include the "Past results are not necessarily indicative of future results" disclaimer when the promotional material piece includes actual trading profits. Remember that this disclaimer is required to be displayed any time actual profits are discussed. As a general rule, you should display the disclaimer on the same page as the actual trading profits.

It is also important that you are able to support all material statements included in your promotional material. Material statements are statements made in the promotional material that refer to a firm's successful trading record or service, such as "In the past ten years, we have had only four losing months" or "We've been voted the best online trading platform three years running". If you use these types of statements, you must maintain documentation to demonstrate that such claims are factually accurate.

Another promotional material area where we have found deficiencies is the presentation of hypothetical performance results. Specifically, when displaying these results, some firms do not clearly identify them as hypothetical, include the hypothetical disclaimer or disclose the material assumptions used when calculating the performance.

If you decide to use hypothetical performance results in your promotional material, you need to follow these procedures:

  • Include the hypothetical disclaimer as required by CFTC Regulations immediately before the performance results, if the firm has less than 12 months of actual results, or after the performance results if more than 12 months of actual results. Also, you should display the disclaimer in at least the same type size as the hypothetical results.

  • Include past performance results of all customer accounts directed by the firm, Associated Person or account manager for at least five years or since the beginning of trading, if less than five years.

  • Include the past performance for proprietary accounts, if the firm or AP has less than one year experience in directing customer accounts.

  • Present the actual performance results as prominently as the hypothetical results, if the promotional material includes both actual and hypothetical performance results. Furthermore, both the actual and hypothetical performance results must be appropriately identified, separately formatted, discussed in an equally balanced manner, and calculated according to the same rate of return method.

  • Describe material assumptions used when calculating the hypothetical performance. At a minimum, you should include the initial investment amount, reinvestment of profits, commission charges, management and incentive fees, and how the sales prices for the trade is determined.

You should also remember that you cannot use hypothetical performance results if your firm has three months of actual performance for the same trading program, unless the material is exclusively directed to persons who meet the standards of Qualified Eligible Person.

One way to avoid regulatory deficiencies in promotional material is to take advantage of our Promotional Material Pre-Review program. This service is provided free of charge and allows Members to receive feedback on their promotional material prior to its use. An NFA promotional material specialist will review the material and, if apparent deficiencies are noted, will inform you of the deficiencies and make suggestions on how it can be corrected.

Supervision
NFA Compliance Rule 2-9 places a continuing responsibility on every Member to diligently supervise its employees and agents in all aspects of their futures activities. Given the differences in the size and complexity of the operations of NFA Members, NFA allows for some degree of flexibility in determining what constitutes "diligent supervision" for each firm.

However, we have discovered during audits that some Members are not conducting annual on-site visits of its branch offices or Guaranteed Introducing Brokers (GIBs). If you have branch offices or GIBs, you should develop written procedures for your on-site review process that include what work will be performed during the on-site visit, how often they will occur, and that a written report will be prepared and follow-up work will be completed to ensure that deficiencies are corrected. The on-site review should cover several areas including the customer order process, discretionary trading, sales practices, customer complaints, handling of customer funds and proprietary trading. For further guidance regarding on-site visits and other supervisory requirements, please review NFA's Interpretive Notice for Supervision of Branch Office and Guaranteed IBs.

Available Resources
As a reminder, all of NFA's rules, interpretive notices and regulatory guides are available on our Web site (www.nfa.futures.org). Also, if you have any questions regarding any of the information discussed above, please contact NFA's Information Center at (800) 621-3570. An Information Center Representative will forward your call to the appropriate Compliance contact person.

News,Facts,Actions would like to thank Compliance staff members Patricia Cushing, Amy McMann and Regina Thoele for their contributions to this article.

NFA is the premier independent provider of efficient and innovative regulatory programs that safeguard the integrity of the derivatives markets.
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