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Notice I-04-16

September 17, 2004

CFTC Adopts Risk-Based Capital Requirement (Effective September 30, 2004)

The Commodity Futures Trading Commission (CFTC) has amended several of its regulations relating to minimum financial and reporting requirements, and NFA has adopted conforming changes to its Financial Requirements. These amendments become effective September 30, 2004.

Capital and Early Warning Requirements

The CFTC has adopted a risk-based capital requirement that mirrors NFA's existing requirement. Since this is an existing NFA requirement, the CFTC's risk-based requirement will not change the way FCMs calculate their minimum capital requirements.

The CFTC eliminated the alternative capital requirement based on segregated funds, and NFA made conforming changes to its Financial Requirements. Therefore, FCMs may no longer use the percentage of segregated funds alternative when determining if they meet their minimum capital requirements. The Form 1-FR-FCM has been revised to incorporate these changes.

The CFTC amendments also revise the early warning computation. Those amendments delete the early warning requirement based on segregated funds and adopt an early warning level at 110% of the risk-based capital requirement.

Eligibility to Guarantee IBs

Section 2 of NFA's Financial Requirements restricts an FCM's ability to guarantee IBs if it does not maintain capital in excess of its minimum net capital requirement. The capital required to guarantee IBs is designed to mirror the CFTC's early warning requirements. Therefore, NFA amended Section 2 by eliminating the reference to segregated funds and by increasing the risk-based capital amount to 110% of the minimum net capital requirement.

Subordinated Debt and Equity Withdrawal Requirements

The CFTC has adopted conforming amendments to the subordinated debt and equity withdrawal requirements. In particular, the amendments eliminate the restrictions based on segregated funds and replace them with restrictions based on the risk-based capital amount.

The CFTC's capital requirements allow firms to exclude subordination agreements from the firm's liabilities when calculating capital if those agreements contain certain restrictions on repayment. Under the amendments, a satisfactory subordination agreement must provide that the loan will not be paid if the firm's adjusted net capital is less than:

a) 120% of risk-based capital for permissive prepayments of subordinated loans that have been outstanding for more than one year;

b) 125% of risk-based capital for special prepayments of subordinated loans that have been outstanding for one year or less; and

c) 120% of risk-based capital for suspended repayments of subordinated loans, to provide notice of maturity or accelerated maturity of subordinated loans, and for restrictions on the use of temporary subordinated loans.

The CFTC is grandfathering in agreements that are in effect as of September 30, 2004. These agreements will continue to be satisfactory subordination agreements even though they do not include the risk-based restrictions on repayments. If the agreement is amended or renewed, however, it must meet the new requirements.

The CFTC's capital requirements also contain restrictions on withdrawing equity if the firm's capital is below a certain amount. The new risk-based withdrawal restriction is 120%.

Notice Requirements

The CFTC shortened the time periods for notifying the CFTC and the firm's DSRO of certain events.

• The firm must file notice within 24 hours after the firm knows or should have known that its adjusted net capital has fallen below the early warning level.

• The firm must file notice that it has failed to maintain current books and records on the day the failure occurs. While the initial notice requirement has not changed, the firm now has only 48 hours to file the written report describing the actions the firm has taken or will take to correct the problem.

• The firm must file notice of material inadequacies in its books and records within 24 hours after it discovers or is notified of the material inadequacy. The firm has 48 hours to file the written report describing the actions the firm has taken or will take to correct the problem.

Financial Reporting Requirements

Finally, the CFTC adopted several changes to its financial reporting requirements. First, the amendments provide that the firm's DSRO or designated examining authority may grant requests to change the firm's fiscal year and requests to extend the time to file unaudited Form 1-FRs and annual certified statements. FCMs for which NFA is the DSRO should direct these requests to NFA with a copy to the CFTC or to its DEA with copies to NFA and the CFTC. If the firm submits the request to its DEA, it must promptly provide its DSRO and the CFTC with a copy of the DEA's response granting or denying the request.

Second, the CFTC amended Regulation 1.10(d)(4) to clarify who can attest to the accuracy of Form 1-FR. The amendment addresses different organizational structures and includes limited liability companies and limited liability partnerships.

Questions concerning these requirements should be directed to Sharon Pendleton, Associate Director, Compliance, at spendleton@nfa.futures.org or (312) 658-6540 or to Tracey Hunt, Team Manager, at thunt@nfa.futures.org or (312) 658-6835.