9013 - NFA COMPLIANCE RULE 2-30: CUSTOMER INFORMATION AND RISK DISCLOSURE
(Staff, November 30, 1990; revised July 1, 2000)
NFA's Know-Your-Customer Rule, which deals with customer information and risk disclosure, has been in effect since June 1, 1986. As drafted by NFA's Advisory Committees and approved by the Board of Directors, the Rule was designed to accomplish two primary objectives:
1. to define "high standards of commercial honor and just and equitable principles of trade" as applied to Member procedures for exchanging information with new customers who are individuals; and
2. to provide a useful tool to combat any unscrupulous firms attempting to take advantage of unsophisticated investors.
Given these broad purposes, some of the Rule's provisions are very specific, while others, of necessity, are more general. Since some of the Rule's provisions are stated in general terms, Members may understandably seek more specific guidance on some points. The best sources for such guidance are the Interpretive Notice to Rule 2-30 ("Interpretive Notice")1, and the decisions NFA's Regional Business Conduct Committees ("BCCs") and Hearing Panels have made in specific disciplinary cases which allege violations of the Rule. The purpose of this Notice is to provide Members with additional guidance in complying with Rule 2-30 by summarizing how the BCCs have applied Rule 2-30 since the Rule became effective in 1986.
Since Rule 2-30 became effective, a number of complaints have been filed by NFA which allege violations of the Rule. Typical violations of the Rule generally fall into one of three categories.
1. failing to give additional risk disclosure when required or disguising the fact that additional risk disclosure may be required by inducing customers to provide false information on their account opening papers;
2. violations of recordkeeping requirements; and
3. violations of supervisory requirements.
A description of typical violations in each category is set forth below.
Inadequate Risk Disclosure
The heart of Rule 2-30 is the requirement that Members obtain certain basic information from the customer concerning his financial background, analyze that information and ensure that the customer has received adequate risk disclosure information. As discussed in the Interpretive Notice, some customers may require risk disclosure in addition to that specifically prescribed by Rule 2-30(d)2. For example, there may be instances where, for some customers, the only adequate risk disclosure is that futures trading is too risky for that customer. Once adequate disclosure is given, however, the customers are free to decide whether to trade in futures and the Member is free to accept the account. The Rule recognizes that the identification of customers who require additional risk disclosure can only be done on a case-by-case basis and that the determination of whether additional risk disclosure is required for a given customer is best left to the Member firm, subject to review by the BCCs.
The most serious violations of the Rule have involved either failing to provide additional risk disclosures when necessary or inducing customers to provide false information on their account opening forms. A number of the more egregious cases, which have generally resulted in expulsions from NFA membership, are summarized below. The exact factual circumstances vary from case to case, but one common thread in these cases is that the customer had no previous futures trading experience and little, if any, other investment experience. Obviously, these extreme examples do not in any way limit the circumstances which may trigger a need for additional risk disclosures:
- An AP instructed a customer, who noted on his account opening forms that he had owned his own home for 18 years, to falsify his account application by indicating that he had been involved in real estate development for 18 years.
- An AP solicited a 52-year-old retired Air Force Colonel who had no prior commodity trading experience. The AP did not advise the customer of any specific numbers to put down on his account opening form regarding his net worth, but told him to make the numbers high enough to get the account approved.
- An AP solicited a 32-year-old nurse and her husband, a 39-year-old computer operator, neither of whom had any prior investment experience in commodities or securities. The customers repeatedly informed the AP that they could not afford a minimum required investment of $10,000. The AP told them to take out a loan from their credit union and that the required investment amount would then be reduced to $5,000. The customers subsequently took out a $3,000 loan from their credit union and added $2,000 from their savings account to meet the $5,000 minimum investment requirement. The husband then went to the firm's office and signed the account forms during his 30-minute lunch break; however, he did not read the forms, nor were they explained to him by the firm or its AP.
- An AP instructed a customer to inaccurately complete his account application by stating that he was a foreman rather than a factory laborer, and by indicating that he had liquid assets in the amount of $51,000 instead of $20,000. Another of the firm's APs told a customer that his actual annual income of $12,500 was too low and that if he did not change that figure to read between $20,000 and $40,000, his account would be rejected.
- A customer who had been unemployed for two years, with a net worth of $30,000 derived from an inheritance and sale of property and no futures trading experience, was instructed by an AP to "put down anything" on the account opening form regarding her employment and income. The customer received no risk disclosure other than the Risk Disclosure Statement required by CFTC Regulation 1.55. In addition, the AP neither explained the account documents to the customer, nor gave her sufficient time to review them.
- An AP solicited a 77-year-old retired real estate investor with a net worth of $100,000 and a fixed annual income of $20,000. The customer informed the AP that both he and his wife were in ill health and that one of the reasons for his interest in investing in commodity futures contracts was his limited health insurance coverage and a desire to earn enough money to pay for his medical expenses. Rather than providing the customer with risk disclosure in addition to that contained in the risk disclosure statements, the AP informed the customer that the risk of loss involved in futures trading was slight. Another of the firm's APs instructed a customer not to put down "unemployed actor" for his occupation but rather "self-employed." This AP also advised the customer to include a net worth figure on his account forms which was sufficiently high to insure the opening of the account, and for the income figure, to put down his income prior to becoming unemployed.
Again, the cases summarized above illustrate some of the more egregious violations of the Rule involving either inadequate risk disclosure or inducing customers to provide false information on their account opening forms. However, because the determination of whether additional risk disclosure is required for a given customer can be made only on a case-by-case basis, the above scenarios should not be interpreted to limit the circumstances under which additional risk disclosure may be required.
Recordkeeping and Supervisory Requirements
Though risk disclosure is the heart of the Rule, Compliance Rule 2-30 also imposes certain recordkeeping and supervisory requirements. Violations of these requirements typically involve a failure to obtain all of the information required under the Rule (i.e., occupation, current estimated annual income and net worth, approximate age and previous investment and futures trading experience) or a failure to retain the appropriate records. Although the Rule 2-30 recordkeeping violations have never formed the sole basis of disciplinary actions, they generally are indicative of a widespread recordkeeping problem within the firm.
Rule 2-30(h) requires each Member to "establish and enforce adequate procedures to. . . supervise the activities of its Associates in obtaining customer information and providing risk disclosure." One case alleging a violation of Rule 2-30(h) involved the failure of a firm's account opening procedures to require that the firm's APs obtain the necessary information from the customer. Another case involved a firm whose APs failed to follow guidelines provided to the firm by its guarantor in order to determine whether a prospective customer needed additional risk disclosure. Rule 2-30(h) does not require Members to provide their APs with any sort of grid-like formula to identify those customers who require additional risk disclosure; however, the Rule, as applied by the BCCs and Hearing Panels, does require that a firm be able to articulate the general factors its APs are instructed to consider in determining whether additional risk disclosure is required.
In conclusion, NFA recognizes that certain provisions of Compliance Rule 2-30 are stated in general terms. Since the law in this area is developed on a case-by-case basis by NFA's Hearing Panels, no precise formula is available to Members to aid them in their interpretation of the Rule. However, in addition to the Interpretive Notice, Members may obtain guidance regarding the Rule's application by reviewing the case summaries described above. As the case law in this area continues to develop, NFA will keep Members apprised of any changes in the Rule's application.
1 See NFA Manual at 9004.
2 See NFA Manual at 9004.