INTERPRETIVE NOTICE

NFA Compliance Rule 2-10 adopts by reference CFTC Regulation 1.35, which, among other things, imposes on FCMs recordkeeping requirements relating to customer orders on futures and options on futures contracts. The purpose of the regulation is to prevent various forms of customer abuse, such as fraudulent allocation of trades, by providing an adequate audit trail that allows customer orders to be tracked at every step of the order processing system. In general, Regulation 1.35 requires a futures commission merchant ("FCM") receiving a customer order to prepare a written record of the order immediately upon receipt, including an appropriate account identifier.

With respect to bunched orders placed by an account manager on behalf of multiple clients, the CFTC had interpreted Regulation 1.35 to require that, at or before the time the order is placed, the account manager must provide the FCM with information that identified the accounts included in the bunched order and specified the number of contracts to be allotted to each account.^1 2 An exception to this requirement was set forth in Regulation 1.35(a-1)(5), which authorized certain eligible account managers to enter bunched orders for a limited class of eligible clients and to allocate them to individual accounts no later than the end of the day ("post-execution allocation procedures").

How the basic requirements of CFTC Regulation 1.35 applied to bunched orders for multiple accounts had been the source of considerable difficulty and confusion. In June 1997, therefore, NFA published an Interpretive Notice to provide guidance to its Members in complying with these requirements ("1997 Notice"). While this Notice did not attempt to address all of the issues that can arise in this context, it provided guidance on recurring questions.

The CFTC recently adopted an amendment to Regulation 1.35(a-1)(5). This amendment effectively removes the limitations on the account managers that may take advantage of post-execution allocation procedures as well as the limitations on the types of clients on whose behalf the account managers may employ post-execution allocation procedures. In particular, all registered commodity trading advisors ("CTAs") that are Members of NFA may take advantage of the procedures in Regulation 1.35(a-1)(5) for the accounts of all clients who grant written investment discretion to the CTA.

The amendment also clarifies the obligations imposed on account managers that wish to take advantage of these post-execution allocation procedures as well as the FCMs that execute or clear these transactions. Among other things, the rule requires that contracts executed pursuant to bunched orders be allocated in a fair and equitable manner so that no account or group of accounts consistently receives favorable or unfavorable treatment over time. The rule further provides that the account manager bears the responsibility for the fair and equitable allocation of bunched orders, while FCMs retain the responsibility to monitor for unusual allocation activity.

Because all NFA CTA Members may now take advantage of post-execution allocation procedures under Regulation 1.35(a-1)(5), NFA has determined to revise the 1997 Notice. This revised Notice sets out certain core principles that govern all allocation methodologies and the respective responsibilities of CTAs and FCMs that execute or carry the accounts of the CTAs' clients. The Notice then restates certain methodologies described in the 1997 Notice. Although these methodologies were developed to assure compliance with the requirement that a CTA provide allocation instructions at or before the time a bunched order is placed, they also apply to CTAs that elect to use post-execution allocation procedures.

Core Principles and Responsibilities

Allocation instructions for trades made through bunched orders for multiple accounts must deal with two separate issues. The first, which arises in all such orders, involves the question of how the total number of contracts should be allocated to the various accounts included in the bunched order. For some CTAs, this allocation may remain relatively constant. For others, although their basic allocation methodology does not change, the specific allocation instructions produced by the methodology may change on a daily basis.

The second issue involves the allocation of split or partial fills. For example, a CTA may place a bunched order of 100 contracts for multiple accounts. In many instances, however, a market order for 100 contracts may be filled at a number of different prices. Similarly, if an order is to be filled at a particular price, the FCM may be able to execute some but not all of the 100 lot order. In either example, the question arises of how the different prices or the contracts in the partial fill should be allocated among the accounts included in the block order.

The same set of core principles govern the procedures to be used in handling both of these issues. Any procedure for the general allocation of trades or the allocation of split and partial fills must be:

• designed to meet the overriding regulatory objective that allocations are non-preferential and are fair and equitable over time, such that no account or group of accounts receive consistently favorable or unfavorable treatment;³

• sufficiently objective and specific to permit independent verification of the fairness of the allocations over time and that the allocation methodology was followed for any particular bunched order; and

• timely, in that the CTA must provide the allocation information to FCMs as soon as practicable after the order is filled and, in any event, sufficiently before the end of the trading day to ensure that clearing records identify the ultimate customer for each trade.

As noted above, the responsibility for allocating contracts executed through a bunched order rests solely with the CTA.⁴ The CTA must confirm, on a daily basis, that all its accounts have the correct allocation of contracts. A CTA must also analyze each trading program at least once a quarter to ensure that the allocation method has been fair and equitable (i.e., customers in the same trading program achieve similar allocation results over time). Allocation fairness over time, rather than trade-by-trade, is the critical element in this evaluation. If materially divergent performance results exist over time among accounts in the same trading program, such results must be shown to be attributable to factors other than the CTA's trade allocation procedures. Applicable CFTC and NFA interpretations have addressed permitted reasons for divergent performance results among accounts in the same trading program. If those results indicate that the allocation method has not been fair and equitable over time, however, then the CTA must revise its allocation methodology or adopt a different allocation method for application on a prospective basis only. A CTA must document its internal audit procedures and results and maintain these audit procedures and results as firm records subject to review during an NFA audit.

Although the CTA is responsible for the allocation of each bunched order, the FCM has certain obligations as well. In particular, each FCM must receive from an account manager sufficient information to allow it to perform its functions. For executing FCMs in a give-up arrangement, this includes, at a minimum, information that identifies the account manager at the time the order is placed and instructions, which the FCM may receive following execution of the order, for the contracts to be given up to each clearing FCM. Information concerning the number of contracts to be allocated to each account included in the bunched order along with instructions for the allocation of split and partial fills among accounts must be provided to the clearing FCM.⁵

Regulation 1.35(a-1)(5) requires each FCM that executes or carries accounts eligible for post-execution allocation to maintain records that, as applicable, identify each order subject to post-execution allocation and the accounts to which the contracts were allocated. One means by which an FCM can meet this recordkeeping requirement is to maintain a copy of the allocation instructions provided by the account manager by facsimile, e-mail, or other form of electronic transmission. If the allocation is provided orally, however, the FCM must create a written record and maintain that record.

Also, if the FCM has actual or constructive notice that allocations for its customers may be fraudulent, the FCM must take appropriate action. For example, if an FCM has notice of unusual allocation activity, the FCM must make a reasonable inquiry into the matter and, if appropriate, refer the matter to the proper regulatory authorities (e.g., the CFTC or NFA or its DSRO). Whether an FCM has such notice depends upon the particular facts involved.

Obviously, one of the most significant factors is the amount of information available to the FCM. An FCM that both executes and clears an entire bunched order will possess more information than an FCM that executes or clears only a portion of an order. Where there are multiple FCMs executing and clearing the bunched order, some FCMs may have more information available than others, and it is likely that no single FCM would have enough information to determine if there is unusual allocation activity. Likewise, in situations where an investment adviser uses bunched orders for hedging purposes, the FCM may not possess adequate information to evaluate the allocation activity. However, if the FCM has actual or constructive notice that the allocations may be fraudulent, the FCM must take appropriate action.

Examples of Allocation Methodologies

In the 1997 Notice, NFA set out the following examples of procedures for the allocation of split and partial fills that generally satisfy the core principles described above. These methodologies were the most common that NFA observed in performing audits. NFA believes they are still relevant. However, they are not the exclusive means of achieving compliance with Regulation 1.35(a-1)(5). The appropriateness of any particular method, of course, will depend on the CTA's trading strategy.⁶

Example #1 - Rotation of Accounts
One basic allocation procedure involves a rotation of accounts on a regular cycle, usually daily or weekly, which receive the most favorable fills. For example, if a firm has 100 accounts trading a particular trading program, in the first phase of the cycle, Account #1 receives the best fill, Account #2 the second best, etc. In phase 2 of the cycle, Account #2 receives the best fill and Account #1 moves to the end of the line and receives the least favorable fill.

Example #2 - Random Allocation
Some firms prepare on a daily basis a computer generated random order of accounts and allocate the best price to the first account on the list and the worst to the last. This method would satisfy the standards stated above.

Example #3 - Highest Prices to the Highest Account Numbers
Some firms rank accounts in order of their account numbers and then allocate the highest fill prices to the accounts with the highest account numbers. Any advantage the higher numbered accounts enjoy on the sell order are theoretically offset by the disadvantage on the buy orders. Although under certain market conditions this may not always be true, the method generally complies with the standards.

Example #4 - Average Price
With regard to split fills, firms may have internal programs which calculate the average price for each bunched order. The program will then assign the average price to each allocated contract. In the alternative, the program will allocate the actual fill prices among the accounts included in the order to approximate, as closely as possible, the average fill price. Either average price allocation method offers a consistent non-preferential method for allocating trades.

If any Member has questions concerning how this Interpretive Notice would apply to its operations, please contact NFA's Compliance Department.

¹Bunched orders can provide customers with the advantages of better pricing and more efficient execution of orders. With the explosive growth of the managed funds business, the frequency of "give-ups" and the increasing use of electronic order entry systems, it is not at all uncommon for some account managers to place bunched orders for hundreds of accounts on markets around the world, with orders executed by one or more FCMs and cleared by other FCMs.

²Consistent with the provisions of CFTC Regulation 1.35(a-1)(1), account managers that place orders for a single account must still provide account identification information at the time of order entry.

³Because customers must have access to information that allows them to assess the fairness of the allocation process, CTAs are required to make the following information available to customers upon request: (1) the general nature of the CTA's allocation methodology; (2) whether accounts in which the CTA may have an interest may be included with customer accounts in bunched orders; and (3) summary or composite data sufficient for that customer to compare its allocation results with the allocation results of other comparable customers and, if applicable, any account in which the account manager has an interest.

⁴However, NFA rules do not preclude an FCM from agreeing to undertake this responsibility, whether it clears or executes the trades, pursuant to either its own procedures or to those supplied by the CTA. For example, the CTA and FCM may agree that the FCM will allocate a bunched order in accordance with instructions that the CTA files with the FCM either prior to or concurrently with placing the bunched order. Any division of responsibilities agreed to by the FCM and CTA should be clearly documented.

⁵As noted, an account manager must provide all of this information to the appropriate FCM as soon as practicable after the order is filled and sufficiently before the end of the trading day during which the order is executed to ensure that clearing records identify the ultimate customer for each trade.

⁶For example, certain allocation methodologies may satisfy the general standards for CTAs who trade on a daily basis but be inappropriate for CTAs who trade less frequently.