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Relating to the
U.S. Securities and Exchange Commission's
Roundtable on Hedge Funds
May 14-15, 2003
Submitted July 7, 2003
Daniel J. Roth
President & Chief Executive Officer
National Futures Association
In addition to being a registered futures association, the Commodity Futures Modernization Act of 2000 specified a very important role for NFA with respect to security futures products by designating NFA as a limited purpose national securities association. Before these products could begin trading, the CFMA specified that NFA had to have customer protection, suitability, and sales practice rules for security futures that are comparable to NASD rules. NFA worked cooperatively with the CFTC and SEC, as well as the industry, and met all requirements well before security futures were ready to trade.
Our 4,100 Members include futures commission merchants, introducing brokers, CPOs and commodity trading advisors ("CTAs"). We also regulate the activities of approximately 50,000 registered account executives who work for those Members. Approximately half of our Member firms are registered as CPOs and almost 800 are registered as CTAs. Once CPO/CTA registration categories are combined, they represent over 60% of our total firm membership.
Although overall membership tends to remain static, there has been a significant growth in the number of CPOs since 1987. For example, from 1987 to 2002 the number of CPOs has increased by 650 Members or by 50%. A large number of the 650 registered CPOs remain inactive. However, NFA continually monitors all CPO activity through calls for financial statements, annual questionnaires, examinations and disclosure document submissions. This information is input into NFA's databases and reviewed to determine if a firm is active or not.
Currently, there are approximately 900 active CPOs, which operate approximately 2800 active commodity pools. Many of these CPOs have requested relief for certain pools under CFTC Regulation 4.7, which allows relief from recordkeeping, disclosure and reporting requirements if they restrict their solicitation and business to sophisticated high net worth individuals also known as qualified eligible persons. Approximately 1600 pools have received 4.7 relief. Many of these pools are hedge funds.
Much of the growth in CPO Members can be correlated to the growth of hedge funds during the last fifteen years. Not surprisingly, many hedge fund operators or their affiliates are registered as CPOs and are NFA Members. Today, 18 of the top 25 hedge fund complexes are operated by NFA Member CPOs or their affiliates and of the top 100 hedge funds, 55 are NFA Members. In fact, most of the prominent names in the hedge fund business are NFA Members. Additionally, many of the pools that have received 4.7 relief are also hedge funds.
NFA has several programs in place to monitor CPOs for compliance with the various rules and regulations. Specifically, NFA conducts on-site examinations of CPOs and during these exams performs basic testing of all of the pools operated by the CPO. During this testing, NFA reviews each pool's participant list, solicitation material, additions and withdrawals, any transactions between the CPO and any of its pools, transfers between the CPO's pools, and the CPO's banking relationships. After this basic testing, NFA selects one pool for more detailed testing of financial records. During this testing, NFA reviews the assets and liabilities of the pool and determines whether each appear to be reasonably valued. In selecting which pool to select for detailed testing, NFA considers several factors, including the number of participants in the pool, the pool's total net asset value, exemptions held by the pool and whether the pool was detail tested in our prior exams.
NFA currently examines approximately 300 CPOs each year. An initial examination is performed within 2 years of the CPO becoming active and about every 3 years thereafter. For inactive firms, the cycle is longer but NFA visits inactive CPOs at least every 5 years to confirm it is not doing any business. Although our on-site examinations are the most comprehensive way we monitor our Members, we have other programs in place to monitor Member firm activity.
For example, all non-exempt pools must distribute a disclosure document to potential pool participants. NFA reviews 100% of those documents to ensure that adequate disclosure is provided to the investing public about the investments being offered. When we review a disclosure document, we identify areas of concern and ensure that corrective action has been promptly taken. CPOs must receive NFA's approval to use these documents prior to their first use. Last year, we analyzed 700 pool disclosure documents in an average turnaround time of 4 days. Although NFA has been reviewing disclosure documents for private placement pools since 1997, the CFTC recently delegated the review of public pool documents to NFA as well. Therefore, the number of disclosure documents reviewed annually will slightly increase in the future.
NFA believes that the Commission should be apprised of one additional compliance program in place that specifically covers CPOs. Specifically, in addition to the monthly or quarterly reports that CPOs provide each pool participant on the status of their investment, CPOs must provide a year-end financial statement to participants. These statements are typically certified by an independent auditor and are filed with NFA. NFA analyzes these statements generally within 30 days of receipt to ensure that the statements adequately present each pool's assets and liabilities and disclose information in a manner consistent with any disclosure documents on file. Similar to disclosure documents, NFA reviews 100% of the pool financial statements filed at NFA, which amounted to approximately 2850 in the last twelve months. NFA learns the particulars about each CPO's activities by reviewing these pool financial statements and disclosure documents and we use this information to assess the respective risk of each firm.
As previously noted, since NFA began operations, trading volume on U.S. futures exchanges has increased by over 400% and overall customer complaints have actually dropped by over 70%. Despite the fact that CPOs and CTAs comprise 60% of all NFA Member firms, they are only named as respondents in approximately 20% of our enforcement actions and 2% of customer complaints.
NFA appreciates this opportunity to submit these comments to the Commission. As always, NFA offers its assistance to the Commission to facilitate its review of hedge funds. Therefore, if the Commission or its staff have any questions regarding the extensive compliance programs in place to monitor the activities of CPOs, which in many instances operate hedge funds, please contact me.