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May 24, 2007
Disclosure of Conflicts of Interest by CPOs and CTAs
Commodity pool operator ("CPO") and commodity trading advisor ("CTA") NFA Members are generally required to provide customers with a Disclosure Document that includes material information so as to permit customers to make an informed decision before investing.1 Among other things, the Disclosure Document must include a full description of any actual or potential conflicts of interest, including any arrangement whereby the Member or any principal thereof might benefit directly or indirectly from requiring the maintenance of accounts with a specific futures commission merchant ("FCM") or the introduction of accounts through a particular introducing broker ("IB"), such as payment for order flow or soft dollar arrangements.2 This description must include, at a minimum, a disclosure that such an arrangement might act as an incentive for the CPO/CTA to overtrade the account to generate more commission revenue for the FCM and/or IB.
The Commodity Futures Trading Commission ("CFTC" or "Commission") staff has recently expressed concerns that some CPO and CTA Member Disclosure Documents are not providing adequate descriptions of pertinent conflicts of interest that completely inform potential customers of the resulting risk. Moreover, Members and their representatives have asked that NFA provide further guidance regarding those conflicts of interest that must be disclosed and the manner in which they must be described in Disclosure Documents. Accordingly, NFA is providing examples of some of the more common conflicts of interest it has encountered when reviewing Disclosure Documents and guidance as to the type of disclosures that must be provided. While some of the same types of conflicts of interest often arise, each Member and its business pose unique circumstances. You must take into account the facts applicable to your operations in determining what conflicts of interest exist and, thus, must be disclosed. These examples are not exhaustive. When preparing a disclosure document, a CPO/CTA should closely review all relationships that it, its principals, and its employees have with other commodity firms as well as any persons or entities that are providing services to the CPO/CTA, pools or accounts. Particular attention should be paid to any fees or other compensation paid by or to the CPO/CTA directly or indirectly.
CPO/CTA (or an affiliate) is also an IB or FCM
Where the CPO/CTA or an affiliate is also registered as an IB or an FCM, the Disclosure Document must disclose this fact. Further, the customer must be made aware whether or not the customer's or commodity pool's account must be introduced or carried by this related entity. If the account must be introduced or carried by the related entity, the Disclosure Document must make clear that the fees negotiated by the CPO/CTA Member were not done so at arm's length and, further, the CPO/CTA might not have an incentive to seek a lower fee from an unrelated IB or FCM. The Disclosure Document must also include the dollar amount or percentage of total commissions charged that will be received by the related entity. Further, the Disclosure Document must explain that this arrangement might result in an incentive for the CPO/CTA Member to overtrade the account so as to generate additional commission revenue for the IB and/or FCM, and, therefore, itself.
Principal of CPO/CTA is also a principal or associated person of an IB or FCM
The business background of any principal of the CPO/CTA that is involved with the trading or operational decisions of the Member must be provided in the Disclosure Document. Additionally, if any principal of the CPO/CTA is also a principal or associated person of an IB or FCM through which the accounts must be introduced or maintained, this fact must be disclosed. The Disclosure Document must make clear that the fees negotiated by the CPO/CTA Member were not done so at arm's length and, further, the CPO/CTA might not have an incentive to seek a lower fee from an unrelated IB or FCM. The Disclosure Document must also include the dollar amount or percentage of total commissions charged that will be received by this IB or FCM. Further, it must disclose if the CPO/CTA or its principal will directly or indirectly receive any payments or benefits as a result of introducing or carrying the accounts with the IB or FCM, and fully describe what these payments and benefits are, including the dollar amounts, if applicable. Moreover, the Disclosure Document must explain that this arrangement might result in an incentive for the CPO/CTA Member to overtrade the account to generate additional commission revenue for the IB and/or FCM, and, thereby, indirectly benefit the principal.
CPO receiving payments from a CTA
Where a CPO receives, directly or indirectly, benefits from a CTA to whom it is allocating some or all of the assets in a fund, this must be disclosed. (For example, if the CPO receives a portion of the management fees the CTA is charging the fund). The Disclosure Document must include a full description of such arrangement, including any dollar amounts or value of the benefit being received by the CPO. Additionally, the Disclosure Document must explain that this arrangement provides an incentive for the CPO to continue to use the CTA regardless of its trading performance.
Loans between commodity pools and affiliated entities and persons
A conflict of interest that is occasionally encountered with CPOs is the making of loans by commodity pools to affiliated entities or persons, generally principals of the CPO. In such a situation, the pool's Disclosure Document must disclose this loan and its terms, including the interest rate charged, the basis for this rate and the repayment terms. Additionally, the Disclosure Document must explain what the impact would be on the other participants in the pool in the event of default. If a pool has not made a loan, but reserves the right to do so, the Disclosure Document must disclose this fact. Additionally, the Member must describe the circumstances under which it would make a loan and the standards upon which the terms of the loan, such as the interest rate, will be made or, prior to making such a loan, the member must provide all of the participants with a written description of the loan and its terms.
NFA again cautions Members that these examples are not exhaustive and conflicts of interest may arise in circumstances other than those set forth above. Each set of circumstances is unique and Disclosure Documents should be tailored to the specific circumstances of the Member, so as to provide potential customers with the most complete picture as possible. If you have any questions regarding this notice or disclosure requirements generally, please contact Mary McHenry, Senior Manager at (312) 781-2237 or firstname.lastname@example.org, or Jane Pfeiffer, Senior Analyst at (312) 781-1457 or email@example.com.
1 See 17 C.F.R. §§ 4.21 and 4.31 and NFA Compliance Rule 2-13.
2 See 17 C.F.R. §§ 4.24(j) and 4.34(j).