Notices to Members
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October 3, 1996
Amendments to NFA Compliance Rule 2-29(c) and the Interpretive Notice Relating to the Use of Promotional Material Containing Hypothetical Performance Results
In December 1995, NFA
notified its membership about amendments to NFA Compliance Rule
2-29(c) and its Interpretive Notice which, among other things,
require Members and Associates who utilize hypothetical performance
results in promotional material to (1) provide customers with
an expanded disclaimer; (2) describe all of the material assumptions
which were made in preparing the hypothetical performance results;
and (3) include their actual performance results. Since that time,
further amendments have been made to NFA Compliance Rule 2-29(c)
and its Interpretive Notice. What follows is an explanation of
those amendments.
NFA's Board of Directors determined to amend the
Interpretive Notice to allow the use of extracted performance
results in promotional material. However, the Board realized that
hindsight analysis may be misleading as applied to the presentation
of extracted performance in which a Member selects one component
of its overall past trading results to highlight to customers.
In order to prevent the misleading use of extracted results, the
Interpretive Notice allows the use of extracted performance only
when the Member had previously designated the percentage of assets
which would be committed toward that particular component of the
overall trading program. Furthermore, the Interpretive Notice
requires that any promotional material referring to extracted
results must clearly label those results as such and must disclose
in an equally prominent fashion the overall actual trading results
from which the extracted results were drawn.
NFA's Board believes
that the use of pro forma performance histories can present
useful information to customers, particularly when used to show
how the past performance of a given Member would have been affected
by the commission or fee structure which applies to the futures
or options contracts, commodity pool, or trading program the Member
is offering, recommending, or providing information on. Therefore,
the Interpretive Notice was amended to allow a Member to use pro
forma results to adjust for differences in commissions and
fees as long as the pro forma results
are not calculated in a misleading manner.
NFA's Board also determined to amend the Interpretive
Notice to allow the use of composite performance records in promotional
material. In the past, Members have often referred to composite
performance records as pro forma results. NFA's Board,
however, believes the pro forma label is misleading. Although
the performance for each individual trading advisor is based upon
actual results, the selection of and allocation among trading
advisors has been done with the benefit of hindsight and, thus,
the Board determined that the composite performance record is
hypothetical in nature. The Interpretive Notice allows Members
to use these composite performance records provided they are labeled
as hypothetical and not pro forma. The Interpretive Notice
also states that if a Member previously used promotional material
containing hypothetical composite performance records for multi-advisor
managed accounts or pools and the hypothetical results were substantially
higher than the actual results subsequently obtained by the Member
in allocating assets among the multi-advisors, then this fact
must be disclosed in the promotional material. The Interpretive
Notice also makes clear that the stringent restrictions applicable
to hypothetical results in general also apply to the use of hypothetical
composite performance results.
NFA Compliance Rule 2-29(c) was amended to require
Members to include a disclaimer when using hypothetical composite
performance records which show what a multi-advisor account portfolio
or pool could have achieved in the past if assets had been allocated
among particular trading advisors.
The amendments described above were approved by
the Commodity Futures Trading Commission and became effective
on August 29, 1996.
Disclosure documents and promotional materials currently
in use that are not in compliance with the new amendments referred
to in this notice do not need to be withdrawn. However, all disclosure
documents and promotional materials being used for the first time
or revised after the date of this notice must comply with the
requirements of NFA Compliance Rule 2-29(c).
As amended, NFA Compliance Rule 2-29(c) reads as
follows. A copy of the Interpretive Notice adopted by the Board
is attached.
(c) Hypothetical Results
(1) Any Member or Associate who uses promotional
material which includes a measurement or description of or makes
any reference to hypothetical performance results which could
have been achieved had a particular trading system of the Member
or Associate been employed in the past must include in the promotional
material the following disclaimer prescribed by NFA's Board of
Directors:
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT
LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO
REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY
TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT,
THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL
PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY
ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.
ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE
RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT
OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE
FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY
ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING.
FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE
TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES
ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL
TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO
THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC
TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE
PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF
WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.
If a Member or Associate has either less than one
year of experience in directing customer accounts or trading
proprietary accounts, then the disclaimer must also contain the
following statement:
(THE MEMBER) HAS HAD LITTLE OR NO EXPERIENCE IN TRADING
ACTUAL ACCOUNTS FOR ITSELF OR FOR CUSTOMERS. BECAUSE THERE ARE
NO ACTUAL TRADING RESULTS TO COMPARE TO THE HYPOTHETICAL PERFORMANCE
RESULTS, CUSTOMERS SHOULD BE PARTICULARLY WARY OF PLACING UNDUE
RELIANCE ON THESE HYPOTHETICAL PERFORMANCE RESULTS.
(2) Any Member or Associate who uses promotional
material which includes a measurement or description of or makes
any reference to a hypothetical composite performance record showing
what a multi-advisor account portfolio or pool could have achieved
in the past if assets had been allocated among particular trading
advisors must include in the promotional material the following
disclaimer prescribed by NFA's Board of Directors instead of the
disclaimer prescribed by Section (c)(1) of this Rule:
THIS COMPOSITE PERFORMANCE RECORD IS HYPOTHETICAL
AND THESE TRADING ADVISORS HAVE NOT TRADED TOGETHER IN THE MANNER
SHOWN IN THE COMPOSITE. HYPOTHETICAL PERFORMANCE RESULTS HAVE
MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW.
NO REPRESENTATION IS BEING MADE THAT ANY MULTI-ADVISOR MANAGED
ACCOUNT OR POOL WILL OR IS LIKELY TO ACHIEVE A COMPOSITE PERFORMANCE
RECORD SIMILAR TO THAT SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP
DIFFERENCES BETWEEN A HYPOTHETICAL COMPOSITE PERFORMANCE RECORD
AND THE ACTUAL RECORD SUBSEQUENTLY ACHIEVED.
ONE OF THE LIMITATIONS OF A HYPOTHETICAL COMPOSITE
PERFORMANCE RECORD IS THAT DECISIONS RELATING TO THE SELECTION
OF TRADING ADVISORS AND THE ALLOCATION OF ASSETS AMONG THOSE ADVISORS
WERE MADE WITH THE BENEFIT OF HINDSIGHT BASED UPON THE HISTORICAL
RATES OF RETURN OF THE SELECTED TRADING ADVISORS. THEREFORE, COMPOSITE
PERFORMANCE RECORDS INVARIABLY SHOW POSITIVE RATES OF RETURN.
ANOTHER INHERENT LIMITATION ON THESE RESULTS IS THAT THE ALLOCATION
DECISIONS REFLECTED IN THE PERFORMANCE RECORD WERE NOT MADE UNDER
ACTUAL MARKET CONDITIONS AND, THEREFORE, CANNOT COMPLETELY ACCOUNT
FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FURTHERMORE,
THE COMPOSITE PERFORMANCE RECORD MAY BE DISTORTED BECAUSE THE
ALLOCATION OF ASSETS CHANGES FROM TIME TO TIME AND THESE ADJUSTMENTS
ARE NOT REFLECTED IN THE COMPOSITE.
If a Member or Associate has less than one year of
experience allocating assets among particular trading advisors,
then the disclaimer must also contain the following statement:
(THE MEMBER) HAS HAD LITTLE OR NO EXPERIENCE ALLOCATING
ASSETS AMONG PARTICULAR TRADING ADVISORS. BECAUSE THERE ARE NO
ACTUAL ALLOCATIONS TO COMPARE TO THE PERFORMANCE RESULTS FROM
THE HYPOTHETICAL ALLOCATION, CUSTOMERS SHOULD BE PARTICULARLY
WARY OF PLACING UNDUE RELIANCE ON THESE RESULTS.
(3) Any Member or Associate who uses promotional
material which includes a measurement or description of or
makes any reference to hypothetical performance results which
could have been achieved had a particular trading system of
the Member or Associate been employed in the past must include
in the promotional material comparable information regarding:
(i) past performance results of all customer accounts
directed by the Member pursuant to a power of attorney over
at least the last five years or over the entire performance
history if less than five years;
(ii) if the Member has less than one year of experience
in directing customer accounts, past performance results of
his proprietary trading over at least the last five years or
over the entire performance history if less than five years.
(4) Any Member or Associate utilizing promotional
material containing hypothetical performance results must
adhere to all the requirements contained in the Board's Interpretive
Notice relating to this issue. (See Interpretive Notice at
¶ 9025.)
(5) These
restrictions on the use of hypothetical trading results shall
not apply to promotional material directed exclusively to persons
who meet the standards of a "Qualified Eligible Participant"
under CFTC Regulation 4.7.
Over the years the use of hypothetical performance
results has repeatedly produced highly misleading promotional
material. By their very nature, such performance results have
certain limitations. For example, hypothetical performance results
do not represent actual trading and are generally designed with
the benefit of hindsight which may under- or over-compensate for
the impact of certain market factors, including lack of liquidity
and price slippage. Furthermore, since hypothetical trading does
not involve financial risk, no hypothetical performance results
can completely account for the impact of certain factors associated
with risk, including the ability of the customer or the advisor
to withstand losses or to adhere to a particular trading program
in the face of trading losses. Despite these limitations, there
have been numerous instances in which Members in one form or another
have attempted to induce customers to place undue reliance on
hypothetical results. NFA's Business Conduct Committee has not
hesitated to issue charges against Members engaging in such practices
and will continue to pay close attention to advertising materials
which display hypothetical results.
The use of hypothetical results has been the subject of regulatory scrutiny before. In 1981, the Commodity Futures Trading Commission ("CFTC" or "Commission") considered a total ban on the use of such results. Ultimately, the Commission determined to require CPOs and CTAs displaying hypothetical results to display the disclaimer set forth in CFTC Regulation 4.41. The Commission noted at the time that it might well impose sterner measures if the disclaimer proved ineffective at preventing abuses. NFA subsequently required all NFA Members and Associates to display Regulation 4.41's disclaimer in any promotional material which contains such results.
In NFA's experience, however, the use of the
mandated disclaimer has not prevented recurring abuses in the
presentation of hypothetical results. In some instances Members
have touted dramatic hypothetical profits without revealing that
their actual performance is much worse. This situation has been
addressed by an amendment to NFA Compliance Rule 2-29(c)(2) which
requires Members advertising hypothetical results to disclose
their actual results as well. In other cases Members have effectively
diminished the impact of the disclaimer by grossly over-emphasizing
the significance of very dramatic hypothetical profits. For example,
some Members have utilized promotional material which presents
hypothetical rates of return in large, bold face print while the
disclaimer can be read only with a magnifying glass. In other
advertising pieces the disclaimer is so far removed from the touted
hypothetical profits that customers may never find it. There have
also been instances in which Members or Associates have attempted
to disguise hypothetical performance results as actual performance
results.
Due to these problems, NFA's Board of Directors
recently reviewed whether NFA Members and Associates should be
permitted to utilize hypothetical performance results in promotional
material. During this review, the Board considered a complete
ban on the presentation of these results in promotional material
due to its potentially abusive and misleading nature. However,
in considering such a ban, the Board also recognized that the
presentation of hypothetical performance results in promotional
material may have some limited utility in certain circumstances,
for example, where a Member has developed a new trading program
for which there are no actual trading results. As a result, the
Board decided to continue to allow Members and Associates to utilize
promotional material containing hypothetical performance results
under very stringent restrictions. Hypothetical results will not
be allowed, however, for any trading program for which the Member
has three months of actual trading results. Any Member or Associate
utilizing promotional material which includes hypothetical results
shall, at a minimum, adhere to the following requirements.
First, any Member or Associate utilizing promotional
material which presents hypothetical performance results must
provide to customers the disclaimer contained in NFA Compliance
Rule 2-29(c)(1). The Board has expanded the required disclaimer
to provide a more thorough discussion of the limitations of hypothetical
results and of the dangers in placing reliance upon them. To prevent
the over-emphasis of hypothetical performance results, the disclaimer
must be displayed as prominently as the hypothetical results themselves.
Generally, this would require that the disclaimer be printed in
a type size at least as large as that used for the hypothetical
results. Similarly, to avoid circumstances where hypothetical
performance results are presented in one section of the promotional
material with the disclaimer buried in another, the disclaimer
must now immediately precede or follow the performance results.
Whenever the Member or Associate has less than 12 months of
actual results, the disclaimer must immediately precede the hypothetical
performance results. Furthermore, if the promotional material
contains several pages of hypothetical performance results, then
the Member or Associate may need to include this disclaimer more
than once in the material.
Second, any Member or Associate utilizing promotional
material which presents hypothetical performance results must
also describe in the promotional material all of the material
assumptions that were made in preparing the hypothetical results.
At a minimum, the description of material assumptions must cover
points such as initial investment amount, reinvestment or distribution
of profits, commission charges, management and incentive fees,
and the method used to determine purchase and sale prices for
each trade. Members must also make all material disclosures necessary
to place the hypothetical results in their proper context, which
in some instances may go well beyond the prescribed disclaimer.
Furthermore, Members and Associates must calculate hypothetical
performance results in a manner consistent with that required
under the CFTC's Part 4 Regulations.
Third, when any Member or Associate utilizes
promotional material which contains both hypothetical and actual
performance results, then the actual results must be presented
with at least the same prominence devoted to the hypothetical
results. Both the hypothetical and actual performance results
must be appropriately identified, separately formatted, discussed
in an equally balanced manner and calculated pursuant to the same
rate of return method. Furthermore, the promotional material must
not contain any statement which places undue emphasis on the hypothetical
performance results, for example, by discounting or downplaying
the significance of any actual performance results.
NFA's Board of Directors further notes that,
as explained above, the preceding requirements also apply to a
Member or Associate's use of promotional material containing a
composite performance record showing what a multi-advisor managed
account or pool could have achieved if the account's or pool's
assets had been allocated among particular trading advisors. In
the past, Members have often referred to these composite performance
records as pro forma results; however, NFA's Board of Directors
believes the pro forma label is misleading. Although the
performance for each individual trading advisor is based upon
actual results, the selection of and allocation among trading
advisors has been done with the benefit of hindsight and, thus,
the composite performance record is hypothetical in nature. Therefore,
in addition to the preceding requirements, Members and Associates
must appropriately label any composite performance record for
a multi-advisor managed account or pool as hypothetical and not
pro forma. Additionally, because the composite performance
record is hypothetical in nature, Members must include a description
of all the material assumptions noted above and, in this context,
also describe the method used to select and allocate assets among
particular trading advisors. The Board also notes that if a Member
or Associate previously used promotional material containing hypothetical
composite performance records for multi-advisor managed accounts
or pools and the hypothetical results were substantially higher
than the actual results subsequently obtained by the Member or
Associate in allocating assets among the multi-advisors, then
this fact must be disclosed in the promotional material.
The presentation of hypothetical performance
results in promotional material is, of course, subject to all
other NFA Requirements. Pursuant to NFA Compliance Rule 2-29(b)(1)
and (2), the ultimate test of any promotional material is whether
the overall impact of the material is misleading or likely to
deceive the public. Although NFA has issued this Interpretive
Notice, the Board recognizes that it cannot describe every manner
in which promotional material containing hypothetical performance
results may be misleading. The fact that an NFA Member or Associate
has printed the disclaimer required pursuant to NFA Compliance
Rule 2-29 and that the promotional material is in facial compliance
with this Interpretive Notice does not ensure that material is
not misleading.
Promotional material which contains hypothetical
performance results will continue to be carefully scrutinized
by NFA staff. Pursuant to NFA Compliance Rule 2-29(e), Members
and Associates presenting hypothetical results in their promotional
material must be able to demonstrate to NFA's satisfaction the
validity of the presentation of the results. The greater the emphasis
on dramatic hypothetical profits, the greater the Member's burden
in demonstrating the validity of the presentation.
Addressing a different concern, the Board of Directors also believes that
hindsight analysis may be misleading as applied to the presentation
of "extracted performance" in which a Member or Associate
selects one component of its overall past trading results to highlight
to customers. In order to prevent the misleading use of such results,
the use of extracted performance is permitted only when a CPO's
or CTA's previous disclosure documents designated the percentage
of assets which would be committed toward that particular component
of the overall trading program. For example, if the previous disclosure
document stated that 25 percent of a fund's assets would be dedicated
to trading financial futures contracts, and if 25 percent of the
fund's assets were in fact dedicated to trading financial futures
contracts, the CPO would be allowed to present the extracted performance
of its financial futures trading based on net asset values equal
to 25 percent of the fund's total net asset value. Performance
may also be extracted from a managed account program run by an
FCM or IB if these same requirements are met. In other words,
the FCM or IB must have previously prepared and distributed to
all customers participating in the trading program a written report
or similar document which designated the percentage of assets
which would be committed toward that particular component of the
overall trading program. Oral representations, or written documents
which were not distributed to the customers, are not sufficient.
Furthermore, any promotional material referring to extracted results
must clearly label those results as such and must disclose in
an equally prominent fashion the overall actual trading results
from which the extracted results were drawn.
Lastly, the Board
of Directors believes that the use of pro forma performance
histories can present useful information to customers, particularly
when used to show how the past performance of a given Member or
Associate would have been affected by the commission or fee structure
which applies to the futures or options contracts, commodity pool,
or trading program the Member or Associate is offering, recommending,
or providing information on. Therefore, a Member or Associate
may use pro forma results to adjust for differences in
commissions and fees as long as the pro forma results are
not calculated in a misleading manner.