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A. INTERPRETIVE NOTICE REGARDING FOREX TRANSACTIONS WITH FOREX DEALER MEMBERS
The Commodity Futures Modernization Act of 2000 (CFMA), which was signed into law on December 21, 2000, amended the Commodity Exchange Act (CEA) to provide that only certain regulated entities may offer off-exchange foreign currency futures and options contracts (forex) to retail customers.1 Under the CFMA, registered futures commission merchants (FCMs) and their affiliates are among the entities that may offer forex contracts to retail customers.2 As described below, NFA Bylaw 306 creates a Forex Dealer Member category for certain NFA Members who act as counterparties to forex transactions with retail customers.3 This category allows NFA to exercise appropriate regulatory jurisdiction over the retail forex activities of these Members without imposing unnecessary, and potentially duplicative, regulatory burdens on Members that are otherwise subject to regulatory oversight for their activities.
Given the differences between off-exchange forex transactions and traditional exchange-traded futures and options, the Board of Directors does not believe that it is appropriate to apply the full array of NFA's futures rules to off-exchange forex transactions. Therefore, rather than simply incorporating off-exchange forex transactions into the definition of "futures," NFA adopted NFA Compliance Rule 2-36 to govern these transactions.
Bylaw 306 and Compliance Rule 2-36 define forex transactions as off-exchange foreign currency futures and options transactions that are offered to or entered into with persons that are not eligible contract participants as defined in Section 1a(12) of the CEA and are limited to those transactions where an NFA Forex Dealer Member is the counterparty or the person offering to be the counterparty. For these purposes, "forex" does not include transactions executed on a contract market, a designated transaction execution facility, a national securities exchange registered pursuant to Section 6(a) of the Securities Exchange Act of 1934, or a foreign board of trade, which continue to be covered by other regulatory schemes.
Consistent with the provisions of Section 2(c) of the CEA, Bylaw 306 and Compliance Rule 2-36 apply only to transactions with retail customers. In developing its forex requirements, NFA's primary concern was to ensure that they provide adequate protection for retail customers without imposing undue burdens on NFA Members. NFA also believes that its requirements should, where consistent with customer protection, promote innovation and competition. In order to provide Members with as much flexibility as possible, NFA has chosen to deal with a number of issues by providing guidance under NFA Compliance Rule 2-36 instead of by adopting additional rules.
NFA Compliance Rule 2-36 sets out the general standards that apply to Forex Dealer Members and their Associates in connection with forex transactions with retail customers. Subsection (b) prohibits Forex Dealer Members and their Associates from engaging in fraudulent activities, subsection (c) requires Forex Dealer Members and their Associates to observe high standards of commercial honor and just and equitable principles of trade in connection with their forex business, and subsection (e) requires Forex Dealer Members and their Associates with supervisory duties to supervise their employees and agents. Other subsections address a Forex Dealer Member's responsibility for its unregulated affiliates and third-party solicitors, make Forex Dealer Members subject to discipline for the conduct of certain non-Members with which they do business, and extend certain of the rule's requirements to other Members and Associates who do business with Forex Dealer Members.
This notice has three sections. The first section explains who qualifies as a Forex Dealer Member under NFA Bylaw 306, the second section provides additional guidance about the requirements in Compliance Rule 2-36, and the third section covers other miscellaneous requirements.
A. BYLAW 306
In general, Forex Dealer Members are NFA Members who act as counterparties to retail, off-exchange forex futures and options transactions. This is a self-executing requirement, which means that any Member who qualifies is automatically a Forex Dealer Member. There is no application form and no approval requirement.
Members who do not act as counterparties are not Forex Dealer Members, even if they introduce or manage retail forex accounts. Under NFA Compliance Rule 2-36(g), however, most Members who introduce retail forex accounts to Forex Dealer Members or manage retail forex accounts for customers of Forex Dealer Members are required to comply with subsections (a), (b), (c), and (e) of that rule.
Bylaw 306(b) excludes Members that are otherwise subject to regulatory oversight for their retail forex activities, which means that these Members are not Forex Dealer Members and do not have to comply with Compliance Rule 2-36.4 The exclusions mostly follow Section 2(c)(2)(B)(ii) of the CEA, although the exclusions for broker-dealers and their affiliates are conditioned on NASD membership. In particular, the following entities are not Forex Dealer Members:
As noted above, this section provides additional guidance on what Compliance Rule 2-36 requires. Certain sections specifically refer to Forex Dealer Members. Except for Members that meet the criteria in Bylaw 306(b), all other provisions of this notice also apply to Members and their Associates who solicit retail forex transactions on behalf of a Forex Dealer Member, introduce retail customers to a Forex Dealer Member, or manage accounts for retail customers that enter into forex transactions with a Forex Dealer Member. This notice does not apply to transactions with counterparties listed in Bylaw 306(b) or to transactions between Forex Dealer Members and eligible contract participants.
1. Disclosure -
At or before the time a retail customer first engages in a forex transaction, a Forex Dealer Member and its Associates should provide the customer sufficient information concerning the characteristics and particular risks of entering into forex transactions.
At or before the time a retail customer first engages in a forex transaction, a Member and its Associates should disclose how the Member will be compensated for the services it will provide to the customer.
Forex Dealer Members should provide both the bid and the offer when the customer enters an order.
2. Reporting - Forex Dealer Members must provide retail forex customers with timely and accurate notice of the status of their accounts.
Forex Dealer Members should provide written confirmations within one business day after any activity in the retail customer's account, including offsetting transactions, rollovers, and deliveries. The confirmation should include the details of the transaction as well as
Forex Dealer Members should provide regular monthly summaries of all forex transactions and other account activity to retail customers for all accounts that have open positions at the end of the month or changes in the account balance since the prior statement. Forex Dealer Members should provide summaries at least quarterly for all other open accounts.
With the customer's consent, confirmations and monthly summaries may be transmitted by electronic means.
3. Supervision - Members and their Associates having supervisory responsibilities must diligently supervise the Member's forex business, including the activities of the Member's Associates and agents. Members must establish, maintain, and enforce written supervisory procedures.
NFA has provided Members with guidance on minimum standards of supervision through interpretive notices issued under NFA Compliance Rule 2-9.7 In these interpretive notices NFA recognized that, given the differences in the size of and complexity of the operations of NFA Members, there must be some degree of flexibility in determining what constitutes "diligent supervision" for each firm. This principle also applies to the supervision of a Member's forex business.
Although Members have the flexibility to design procedures that are tailored to their own situation, an adequate program for supervision would include procedures for performing day-to-day monitoring. These procedures would include:
Finally, a Member's supervisory responsibilities include the obligation to ensure that its employees are properly trained to perform their duties. The formality of a training program will depend on the size of the firm and the nature of its business. Procedures should be in place to ensure that supervisory personnel know and understand the firm's supervisory procedures and that employees receive adequate training to abide by NFA requirements and to properly handle retail customer accounts.
4. Recordkeeping - Members must keep books and records relating to their forex operations for a period of five years from the date thereof and shall keep them readily accessible during the first 2 years of the 5-year period. All such books and records shall be open to inspection by NFA.
Members should adopt and enforce reasonable procedures to create current and accurate books and records and to keep them from being altered or destroyed. The Member should be able to promptly produce its records in a format that NFA can read and reproduce.
5. Communications with the Public and Promotional Material - No Member or Associate shall make any communication with potential or current retail customers that operates as a fraud or deceit; uses a high-pressure approach; or implies that forex transactions are appropriate for all persons. Promotional material used by the Member or Associate shall not deceive the public; contain any material misstatement of fact; mention the possibility of profit unless accompanied by an equally prominent statement of the risk of loss; or include any reference to actual past trading profits without mentioning that past results are not necessarily indicative of future results.
No Member or Associate may represent that forex funds deposited with a Forex Dealer Member are given special protection under the bankruptcy laws.
No Member or Associate may represent that its services are commission free without prominently disclosing how it is compensated in near proximity to that representation.
Members and Associates may not solicit customers based on the leverage available unless they balance any discussion regarding the advantages of leverage with an equally prominent contemporaneous disclosure that increasing leverage increases risk.
Every Member should adopt and enforce written procedures to supervise communications with potential and current retail customers and promotional material. A supervisory employee should review and approve all promotional material.
All promotional material should be maintained by each Member and be available for examination for the periods specified in the recordkeeping section of this notice, measured from the date of last use.
6. Know Your Customer - Members and Associates have a duty to acquaint themselves sufficiently with the personal and financial circumstances of each retail forex customer to determine what further facts, explanations and disclosures are needed in order for the customer to make an informed decision on whether to enter into forex transactions.
Every Member should determine what information it will obtain from a prospective retail forex customer. At a minimum, the Member soliciting the retail customer to engage in forex transactions with a Forex Dealer Member should obtain the customer's name, address, principal occupation or business, current estimated annual income and net worth, approximate age, and an indication of the customer's previous investment and trading experience. Members and their Associates need to ensure that each retail customer they solicit has received adequate information concerning the risks of forex transactions so that the customer can make an informed decision as to whether forex transactions are appropriate for the customer. These obligations fall on the Forex Dealer Member when a non-Member solicits the customer.
7. Doing Business with Non-Members - Forex Dealer Members are subject to discipline for the activities of most non-Members who solicit or introduce retail forex customers to the Forex Dealer Member or manage accounts for those customers.
If a customer is solicited or introduced by a non-Member of NFA, or if the customer's account is managed by a non-Member, the Forex Dealer Member is subject to discipline for the non-Member's conduct if that conduct would violate NFA requirements when engaged in by an NFA Member. In other words, a Forex Dealer Member is subject to an NFA disciplinary action for the non-Member's activities when soliciting, introducing, or managing accounts for the Forex Dealer Member's retail customers even if the non-Member was not the Forex Dealer Member's agent.
The rule allows NFA to bring a disciplinary action even if the Forex Dealer Member acts diligently and has no knowledge of the third-party's conduct. As a practical matter, however, NFA will not take disciplinary action unless the Forex Dealer Member knew or should have known of the third-party's conduct or failed to exercise due diligence when establishing and maintaining the relationship with the third party.
The Forex Dealer Member is not subject to discipline for the actions of non-Members who are described in NFA Bylaw 306(b). It is also not subject to discipline for the actions of non-Members who would be exempt from Commission registration if they were acting in the same capacity in connection with exchange-traded futures contracts, such as foreign persons that solicit, introduce, or manage accounts for foreign customers only.10 The Forex Dealer Member does, of course, have certain basic duties to its customers, including a duty to supervise its own activities in a way designed to ensure that it treats its customers fairly. Specifically, the Forex Dealer Member would violate this duty if it has actual or constructive notice that one of these entities engaged in fraudulent conduct and fails to take appropriate action.
8. Affiliates - Forex Dealer Members must supervise and are subject to discipline for the activities of affiliates that are authorized to engage in forex transactions solely by virtue of their affiliation with a Forex Dealer Member.
The CEA authorizes affiliates of FCMs to act as counterparties to forex transactions with retail customers if the affiliate directly or indirectly controls, is controlled by, or is under common control with the FCM and the FCM makes and keeps records regarding the financial activities of the affiliate for purposes of the Commission's risk assessment requirements.11 If a Forex Dealer Member has one or more affiliates that act as counterparty to retail forex customers solely on the basis of that affiliation, the Forex Dealer Member must supervise the affiliate's retail forex activities and is subject to discipline for that affiliate's activities.12 The Forex Dealer Member must also make these affiliates' books and records available to NFA upon request.
C. OTHER REQUIREMENTS
This section of the notice provides guidance on dues, capital requirements, and security deposits. These requirements apply only to Forex Dealer Members.
1. Bylaw 1301
Forex Dealer Members are not required to pay assessment fees on retail off-exchange forex transactions. Instead, NFA Bylaw 1301(e) imposes annual dues that are graduated according to the firm's gross annual revenue from customers (e.g., commissions, mark-ups, mark-downs) for these activities. Profits and losses from proprietary trades are not to be included. To calculate dues:
The dues will be assessed on the firm's membership renewal date and will be based on the Forex Dealer Member's latest certified financial statement.
2. Financial Requirements Section 11
Forex Dealer Members must maintain adjusted net capital equal to or higher than the greatest amount required by Section 11 of NFA's Financial Requirements. For Forex Dealer Members, one of those amounts is 1% of the total net aggregate notional value of all open foreign currency futures and options transactions that are between the Forex Dealer Member and any person that is not an eligible contract participant, including foreign persons. To calculate this capital requirement, follow these steps:
3. Financial Requirements Section 12
Forex Dealer Members must collect security deposits from retail customers equal to 1% of the notional value of transactions in specified foreign currencies and 4% of the notional value of all other transactions. Where the two currencies are in different categories, the Forex Dealer Member must collect the higher amount. If the transaction pairs a foreign currency with the U.S. dollar, the security deposit is based on the foreign currency. If the transaction pairs a currency that qualifies for a 1% deposit with a currency that does not, the Forex Dealer Member must collect a 4% security deposit for the entire transaction. For example:
For short options, the Forex Dealer Member must collect this amount plus the premium the customer received. For long options, the Forex Dealer Member must simply collect the entire premium from the customer.
This requirement does not apply to any Forex Dealer Member that consistently maintains adjusted net capital equal to or in excess of two times the greater of the amount required by Section 11(i) or (ii) of the Financial Requirements. A Forex Dealer Member claiming the exemption must file advance written notice with NFA. If a firm that claims the exemption falls below double its capital requirement under Section 11(i) and (ii), it must immediately notify NFA. If the firm does not come back into compliance within 48 hours, it must collect the required security deposits on all customer positions and may not claim the exemption for six months. A firm that claims the exemption but falls below the required capital amount three times within 90 days may not claim the exemption for six months.13
B. INTERPRETIVE NOTICE FOR COMPLIANCE RULE 2-9 REGARDING ENHANCED SUPERVISORY PROCEDURES
Over the years, NFA's Board of Directors has adopted strict and effective rules to prohibit deceptive sales practices, and those rules have been vigorously enforced by NFA's Business Conduct Committees. The Board notes, however, that by their very nature, enforcement actions occur after the customer abuse has taken place. The Board recognizes that NFA's goal must be not only to punish such deception of customers through enforcement actions but to prevent it, or minimize its likelihood, through fair and effective regulation.
One NFA rule designed to prevent abusive sales practices is NFA Compliance Rule 2-9. Subsection (a) of t
The Board believes that in order for the criteria used to identify firms subject to the enhanced supervisory requirements to be useful, those criteria must be specific, objective and readily measurable. The Board also believes that any supervisory requirements imposed on a Member must be designed to quickly identify potential problem areas so that the Member will be able to take corrective action before any customer abuse occurs. The purpose of this Interpretive Notice is to set forth the criteria established by the Board and the enhanced supervisory procedures which are required of firms meeting these criteria.
In developing the criteria, the Board concluded that it would be helpful to review Member firms which had been closed through enforcement actions taken by the CFTC or NFA for deceptive sales practices. The Board's purpose was to identify factors common to these Member firms and probative of their sales practice problems, which could be used to identify other Member firms with potential sales practice problems.
One factor identified by the Board as common to these firms and directly related to their sales practice problems is the employment history and training of their sales forces. For many of these Members, a significant portion of their sales force was previously employed and trained by one or more of the other Member firms closed for fraud. The Board believes that the employment history of a Member's sales force is a relevant factor to consider in identifying firms with potential sales practice problems. If a Member firm is closed by NFA or the CFTC for fraud related to widespread telemarketing or promotional material problems or a firm is closed by NASD or the SEC for fraud related to its sales practices regarding security futures products as defined in Section 1a (32) of the Commodity Exchange Act ("Act"), it is reasonable to conclude that the training and supervision of its sales force was wholly inadequate or inappropriate. It is also reasonable to conclude that an AP who received inadequate or inappropriate training and supervision may have learned improper sales tactics, which he will carry with him to his next job. Therefore, the Board believes that a Member firm employing such a sales force must have stringent supervision procedures in place in order to ensure that the improper training its APs have previously received does not taint their sales efforts on behalf of the Member.
The Board has determined that a Member will be required to adopt the specific supervisory procedures over its sales practice activities if:
The Board recognizes that there is a group of APs who worked at Disciplined Firms for only a short period of time many years ago and who have not worked at any Disciplined Firm since. The Board's review of the employment and disciplinary histories of such individuals suggests that APs who served a very brief tenure with Disciplined Firms more than ten years in the past do not raise the same concerns regarding their previous supervision and training that are raised by APs who have worked at Disciplined Firms for longer periods or at a more recent point in time. Therefore, the Board has determined that APs who have been previously employed by Disciplined Firms for a cumulative total of less than 60 days and who, in addition, have not been employed by any Disciplined Firm during the 10 years preceding the determination of whether a Member firm is required to employ the enhanced supervisory procedures established in this Interpretive Notice shall not be counted for purposes of calculating whether the composition of a firm's sales force triggers enhanced supervisory requirements.
For purposes of this requirement, a Disciplined Firm is defined very narrowly to include those firms that meet the following three criteria:
2. those charges have been resolved; and
3. the firm has been permanently barred from the industry as a result of those charges;
Attached is a list of firms currently meeting the definition of a Disciplined Firm. Although this list is current as of the date of this Interpretive Notice, NFA will provide Members with updated lists as necessary.
Any Member firm meeting these criteria will be required either to operate pursuant to a guarantee agreement or maintain an adjusted net capital of at least $250,000 for the entire period during which the Member is required to tape record its sales solicitations. Any Member opting to maintain the higher level of adjusted net capital would also be subject to the financial record-keeping and reporting requirements applicable to FCMs. Eligible guarantor futures commission merchants are those that meet the eligibility requirements for executing a Supplemental Guarantor Certification Statement pursuant to NFA Registration Rule 504(a)(2)(B). The Board believes that requiring these Members to operate pursuant to a guarantee agreement will likely improve the overall level of supervision at these firms.
Those Member firms meeting the criteria will be required to tape record all telephone conversations that occur between their APs and both existing and potential customers, including existing and potential retail forex customers of Members subject to NFA Compliance Rule 2-36. The Board believes that tape recording these conversations provides these Members with the best opportunity to monitor closely the activities of their APs and also provides these Members with complete and immediate feedback on each AP's method of soliciting customers. Members meeting the criteria must tape record these conversations for a period of two years and must retain such tapes for a period of five years from the date each tape is created and the tapes shall be readily accessible during the first two years of the five-year period. In retaining the tape recorded conversations, Member firms must catalog the tapes by AP and date. Additionally, any Member firm meeting the criteria must require all its APs to maintain a daily log for sales solicitations which reflects at a minimum the identity of each customer or prospective customer the AP spoke with on each day. A Member firm must be able to promptly produce, upon request from NFA or the CFTC, all conversations relating to a specific AP, and only that AP, for a given date.
In addition, for a period of two years, those Member firms meeting the criteria will be required to file all promotional material, as defined in NFA Compliance Rule 2-29(i), with NFA at least 10 days prior to its first use.
Those Members meeting the criteria shall have written supervisory procedures that include the titles, registration status and locations of the firm's supervisory personnel as these relate to the firm's commodity futures business, retail forex business, and applicable securities laws and regulations for the trading of security futures products. Member firms shall also maintain on an internal record the names of all persons who are designated as supervisory personnel and the dates for which the designation is or was effective. Additionally, a Member meeting the criteria shall by the 30th day of the month following the end of each calendar quarter file with NFA's Compliance Department a report relating to the Member firm's compliance with the supervisory requirements contained herein. Member firms shall retain the internal record and report(s) for a period of five years, the first two years in an easily accessible place.
If an NFA Business Conduct Committee disciplinary proceeding or Commodity Futures Trading Commission enforcement proceeding has been filed against a Member firm required to adopt these enhanced supervisory procedures, then the enhanced supervisory procedures will remain in effect for the applicable time period specified or until after the disciplinary or enforcement proceeding is closed and all appeals are completed or the time for appeal has passed without an appeal being filed or perfected, whichever occurs latest. Member firms shall be required to retain tapes for the five-year period as specified above.
Any Member required to adopt these enhanced procedures may seek a waiver of the enhanced supervisory requirements. NFA may grant such a waiver upon a satisfactory showing that the Member's current supervisory procedures provide effective supervision over its employees, including enabling the Member to identify potential problem areas before customer abuse occurs. Additionally, if a Member meets the criteria and trades security futures products, then the Member firm must also make a satisfactory showing that the Member's supervisory procedures ensure compliance with all applicable securities laws and regulations.
Some of the factors that the three-member Waiver Committee may consider in evaluating a waiver request include:
1 For purposes of this notice, the term "retail customer" refers to any counterparty - domestic or foreign - that is not an eligible contract participant as defined in Section 1a(12) of the CEA.
2 Other NFA Members may offer these contracts if they are also registered in one of the other categories listed in Section 2(c)(2)(B)(ii) of the CEA.
3 The Board of Directors has determined that the retail, off-exchange forex transactions entered into by these firms should be subject to NFA's regulatory jurisdiction and are a proper subject of NFA regulation and oversight under Article XVIII(k) of NFA's Articles of Incorporation.
4 Compliance Rule 2-36(d) and (g) exclude these same entities when they introduce customers to or manage accounts for customers of Forex Dealer Members.
5 Bylaw 306(b)(ii) excludes broker-dealers that are members of any fully-registered national securities association and FCMs that are members of another registered futures association. At this time, however, NASD is the only fully-registered national securities association and NFA is the only registered futures association.
6 These are affiliates of broker-dealers for which the broker-dealer makes and keeps records under the Securities and Exchange Commission's risk assessment requirements. See Section 17(h) of the Securities Exchange Act of 1934 and SEC Rule 17h-1T.
7 See, for example, Compliance Rule 2-9: Supervision of Branch Offices and Guaranteed IBs, NFA Manual paragraph 9019; Compliance Rule 2-9: Supervisory Procedures for E-Mail and the Use of Web Sites, NFA Manual paragraph 9037; Compliance Rule 2-9: Supervision of the Use of Automated Order-Routing Systems, NFA Manual paragraph 9046. These interpretive notices do not apply to off-exchange retail forex activities, but they may provide helpful guidance to Members in connection with those activities.
8 The Commodity Futures Trading Commission has stated that all employees of an FCM who solicit or accept orders for forex transactions from retail customers must be registered with the Commission as an associated person of the FCM. See Division of Trading and Markets Advisory Concerning Foreign Currency Trading by Retail Customers (March 2002).
9 The screening process should include 1) checking BASIC and any other readily available sources and 2) asking the third-party to represent that neither it nor any of its principals is subject to a statutory disqualification or to identify and explain any statutory disqualifications.
10 For this purpose, foreign persons and foreign customers are 1) natural persons who are not residents of the United States or 2) legal entities that are organized under the laws of a country other than the United States, do not have their principal place of business in the United States, and do not conduct their retail forex activities from a location in the United States. "United States" includes U.S. territories and possessions.
11 See Sections 2(c)(2)(B)(ii)(III) and 4f(c) of the CEA and CFTC Regulations 1.14 and 1.15.
12 Obviously, the Forex Dealer Member must also ensure that no entity with common ownership engages in the retail forex business unless it is authorized to do so.
13 For this purpose, underages within the same U.S. calendar day are one occurrence.