Proposed Rule
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(additions are underscored and deletions are stricken)
INTERPRETIVE NOTICE
NFA COMPLIANCE RULE 2-29: COMMUNICATIONS WITH THE PUBLIC AND PROMOTIONAL MATERIAL
(Board of Directors, effective November 19, 1985)
I. Introduction
Section 17(p)(3) of the Commodity Exchange Act (7 U.S.C. § 12(p)(3)) requires that the rules of a registered futures association such as NFA "establish minimum standards governing the sales practices of its members and persons associated therewith. . . ." NFA has established such minimum standards in the form of its Compliance Rules which, among other things, generally prohibit fraud and deceit and require Members and Associates to "observe high standards of commercial honor and just and equitable principles of trade in the conduct of their commodity futures business." Although these rules supply the required minimum standard, they are general in nature and may not always provide specific guidance as to what particular conduct may be prohibited. It is expected that more detailed content will be given to those general rules through the work of NFA's Business Conduct Committees, which will issue decisions in disciplinary cases applying the rules to specific conduct. It is also expected that NFA's Advisory Committees, through study and recommendation of rule changes, will further the development of uniform industrywide sales practice standards.
NFA's Board of Directors has adopted and the CFTC has approved a new Compliance Rule, 2-29, which was proposed to the Board by the FCM Advisory Committee ("The Committee"). The Committee published a notice for public comment on its proposed rule on February 21, 1985, and considered the comments received in drafting the final rule.
II. The Contemplated Relationship of Rule 2-29 With Other NFA Rules
Rule 2-29 deals specifically with communication with the public and promotional material prepared and used in the conduct of a Member's or Associate's futures business. However, Member and Associate conduct in that area, as in all others related to futures, is, and under the new rule continues to be, subject to all other NFA requirements. For example, certain other NFA Rules deal specifically with communications with the public and promotional materials in a narrower context. Compliance Rule 2-13, which incorporates CFTC Rule 4.41, regulates the advertising of Commodity Pool Operators ("CPOs") and Commodity Trading Advisors ("CTAs"). NFA Compliance Rules 2-16 and 2-19 specifically relate to options sales communications and the filing of NFA of option promotional material. In addition, all Member and Associate conduct, including communications with the public, is subject to the requirements of Compliance Rule 2-2 (Fraud and Related Matters) and Compliance Rule 2-4 (Just and Equitable Principles of Trade).
The new Rule is not intended to supplant those or any other NFA Requirements but rather to augment them. Hence, literal compliance with Rule 2-29 will not be a "safe harbor" from NFA disciplinary action if the Member or Associate violates any other NFA Requirement.
III. The Scope of Rule 2-29
Rule 2-29 is intended to apply to all forms of communication with the public by a Member or Associate without exception if the communication relates in any way to solicitation of an account, agreement or transaction in the conduct of the Member's or Associate's business in futures as the term "futures" is now or may be defined.1
However, in drafting the Rule the Committee recognized that some specific standards which would be appropriate for communications prepared in advance of delivery to the public might be unenforceable and even inappropriate in the context of routine day-to-day contact with customers. The Committee was concerned that the free flow of information and advice to customers might be impeded to their detriment if spontaneous communication were subjected to rigorous and detailed content standards.
To address this problem, the final Rule distinguishes routine day-to-day communications with customers and applies a different regulatory standard to such communications. This is accomplished by providing a definition of "promotional material" to identify the kinds of communications with the public which will be subject to specific content standards and other requirements beyond those provided in Section (a) General Prohibition. Therefore, the definition of promotional material (which is a broadened version of the definition of that term in the CFTC's option pilot program rules) is intended to include all kinds of promotional communications with the public, other than routine day-to-day contact with customers. It includes, for example, any kind of written, electronic or mechanically reproduced message or presentation which is directed to any member of the public, whether broadcast over the media, delivered through the mail or presented personally. It also includes any oral presentations or statements to customers or prospective customers, whether delivered over the telephone or in person, the substance of which is outlined or scripted in advance for delivery to such persons.
IV. Section-by-Section Analysis
Section (a) General Prohibition
This Section provides the general rule governing all communications with the public and is the only portion of the Rule applicable to routine day-to-day communication with customers. This means that routine customer contact would not run afoul of Rule 2-29 as long as it is not fraudulent or deceitful, is not high-pressure in nature and does not contain any statement that futures trading is appropriate for all persons. NFA believes that the general prohibition should not hamper free and open communication with individual customers on a day-to-day basis. In that regard, it is expected that Business Conduct Committees would not find such communications to operate as a fraud or deceit in the absence of evidence of such intent or recklessness on the part of the Member or Associate.2
Section (b) Content of Promotional Material
This Section set out the specific prohibitions and requirements applicable to promotional material, as defined. Subsection (1) bans material likely to deceive the public. Proof of violation of this provision does not require proof of a specific intent to deceive. This Subsection instead places the burden on the Member to determine whether the material is likely to be deceptive in effect. Of course, to find a violation of this Subsection a Business Conduct Committee would have to find that the Member or Associate reasonably should have been able to determine that the material was likely to deceive. The fact that someone was actually deceived would not by itself be enough.
Subsection (2) deals with facts only. It requires that the facts which a Member or Associate chooses to include must be true and that no facts knowingly be left out which are necessary to make the facts stated not misleading. With that exception, this Subsection does not require the disclosure of facts. As with Subsection (1), a negligence standard would be applied in finding violations of Subsection (2) for making material misstatements of fact in promotional material. However, because evaluating omissions is a much more difficult task, this Subsection applies only to knowing omissions (i.e., instances where the person preparing or reviewing the promotional material knew the omitted fact and failed to include it). This knowledge requirement may complicate the proof necessary to establish a violation of this Subsection. However, knowledge can be inferred from a pattern of failures to include a material fact, the omission of which makes the promotional material misleading. Once knowledge is established, the decision whether the failure to include a fact makes the promotional material misleading in violation of Rule 2-29 will be made by a Business Conduct Committee under a standard of reasonableness.
Subsection (3) requires a statement of risk to "balance" any discussion of the possibility of profit. The requirement that the statement of risk have equal prominence is not intended to mean that the reference to risk must be as long as the discussion of the possibility of profit or indeed to impose any unbending measure of prominence. It is intended to mean only that in the context of the particular promotional material the reference to risk of loss must not be downplayed or hidden.
Subsection (4) is intended to apply to the presentation of the hypothetical or simulated results of a trading system. It is not intended to apply to references by a Member or Associate to the profit which could have been made if a particular trade had been made or position taken (in order, for example, to illustrate the effect of the lever-age available in futures trading), provided that the balancing statement required under Subsection (3) of the rule is included. Subsection (4) requires all Members and Associates to handle the presentation of hypothetical performance results (whether or not presented or discussed in tabular form) in the same manner as is currently required of CPOs and CTAs. All Members and Associates are required to prominently display the following language along with any hypothetical or simulated performance:
- "HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN."
Subsection (5) (4) requires the Member or Associate to make a statement in the promotional material concerning the predictive value of past results if reference is made in the material to past trading results.
Subsection (6) (5) does not require disclosure of past performance of managed accounts.3 It does require that if performance information is given, it must be representative of actual performance for the same time period of all reasonably comparable accounts. Hence, under Subsection (6) (5) a Member could not advertise the performance of a "model" account unless that performance is representative of all reasonably comparable accounts.4 Subsection (6) (5) also makes explicit in this context the Members' existing responsibility to be able to demonstrate that performance information is accurate and representative.
The use of performance information in promotional material is, of course, subject to all of the content standards of Rule 2-29, and compliance with Subsection (b)(6) (5) will not excuse violations of other Subsections. If in presenting performance information for an account or group of accounts, a Member omits facts about those accounts or the differences between those accounts and the account being promoted, and the omission makes the material misleading, the use of the material violates Subsection (b)(2) even though the performance information given is accurate and is representative of all reasonably comparable accounts in compliance with (b)(6) (5). This interaction of the requirements of Subsections (b)(2) and (b)(6) (5) will come into play whenever a Member chooses to present performance information about an account or program which differs materially from the account or program being promoted - for example, where performance information about a house account is used, or where trading control or strategies, commission rates or account sizes which applied in the account or program for which performance is being shown differ from those which will apply in the account or program for which the customer is being solicited. Under the Rule, a Member is free to use as a sales tool performance information about accounts which differ from the accounts being promoted, but must take care to ensure first, that the performance information complies with Subsection (b)(6) (5), and second, that the differences are explained to the extent necessary to make the promotional material not misleading.
Finally, Subsection (6) (5) requires that the rate of return must not be calculated in a manner inconsistent with that required under the CFTC's Part 4 Rules, which define rate of return as the ratio between net performance and beginning net asset value for the period. This is not intended to require that the precise Part 4 formula be used in all cases but rather to prohibit the use of methods which lead to rates of return which are materially higher than those produced by the Part 4 method.
Section (d) (e) Written Supervisory Procedures
In recognition of the fact that promotional material may be prepared by many individuals within a Member's organization, this Section requires that promotional material be reviewed and approved by someone in a supervisory position before it is used. It should be emphasized, however, that even communications with the public which do not fall within the definition of promotional material must be diligently supervised under other existing NFA and CFTC rules.
Section (e) (f) Recordkeeping
This Section is intended to provide a way in which NFA can conduct meaningful sales practice audits which will reveal both the content of promotional material and whether the supervisory procedures required under Section (d) (e) are being carried out. In addition, this Section contains a requirement that Members who use hypothetical performance results be prepared to demonstrate to NFA's satisfaction the basis for such results. This means that Members must maintain the records necessary to document how the hypothetical results were calculated.
[NOTE: This requirement was extended to all performance results effective __________.]
Section (f) (g) Filing with NFA
This Section is intended to allow NFA to maintain a close review of promotional material in circumstances where special scrutiny is warranted.
[NOTE: This interpretive notice was amended effective __________ to conform it to subsequent changes in NFA rules. In particular, the amendments eliminate the discussion of hypothetical results and update section references within Compliance Rule 2-29 based on changes to Compliance Rule 2-29's treatment of hypothetical results; eliminate references to options rules that are no longer in effect; and make other technical amendments to correspond to subsequent changes to other NFA rules. Furthermore, adjudicated disciplinary decisions are now issued by NFA Hearing Panels rather than Business Conduct Committees. Therefore, all references to Business Conduct Committees, while not changed in the notice, now refer to Hearing Panels. In all other respects, this interpretive notice remains an interpretation adopted by the Board of Directors contemporaneously with the adoption of NFA Compliance Rule 2-29.]
INTERPRETIVE NOTICE
INTERPRETATION OF NFA COMPLIANCE RULE 2-4: GUIDELINE FOR THE DISCLOSURE BY FCMS AND IBS OF COSTS ASSOCIATED WITH FUTURES TRANSACTIONS
(Board of Directors, effective June 1, 1986)
National Futures Association ("NFA") Compliance Rule 2-4 provides that "Members and Associates shall observe high standards of commercial honor and just and equitable principles of trade in the conduct of their commodity futures business." NFA Compliance Rule 2-4 requires that each FCM Member, or in the case of introduced accounts, the Member introducing the account make available to its customers, prior to the commencement of trading, information concerning the costs associated with futures transactions.5
If fees and charges associated with futures transactions are not determined on a per trade or round-turn trade basis, the Member must provide the customer with a complete written explanation of such fees and charges. , including a reasonable example or examples of such fees and charges on a per trade or round-turn basis. Where the per trade or round-turn trade equivalent of the fees or charges may vary widely the most appropriate disclosure would be to explain this fact and provide examples demonstrating the reasonably expected range of the fees or charges. This additional disclosure is not required if:
- 1. the customer has been given a Disclosure Document required by NFA Compliance Rule 2-13 and CFTC Part 4 Regulations;
2. the customer is an NFA Member;
3. the customer has privileges of membership on a contract market; or
4. the customer is not an individual.
To further ensure that information concerning fees and charges has been made available to customers, FCM Members must provide customers with purchase and sale or confirmation statements which include a reasonable breakdown of all fees and charges assessed in connection with all transactions. NFA assessment fees must either be separately itemized from commission or, if they are included among other fees (such as exchange fees, the customer must be given notice at some time of the amount of the NFA assessment fee.
NFA recognizes that FCM and IB Members may employ various arrangements in assessing fees and charges associated with futures transactions to customers. It is NFA's position that aAny such arrangement which is intended to or is likely to deceive customers is a violation of NFA requirements and will subject the Member to disciplinary action.
INTERPRETIVE NOTICE
COMPLIANCE RULE 2-9: SUPERVISION OF BRANCH OFFICES AND GUARANTEED IBS
(Board of Directors, October 6, 1992)
NFA Compliance Rule 2-9 places a continuing responsibility on every Member to diligently supervise its employees and agents in all aspects of their futures activities. Rule 2-9 applies not only to the supervision of branch office operations, but also imposes a direct duty on guarantor FCMs to supervise the activities of their guaranteed IBs. NFA Compliance Rule 2-23 provides that a guarantor FCM may be held jointly and severally subject to discipline by NFA for violations of NFA rules committed by the FCM's guaranteed IBs. In practice, NFA's Business Conduct Committee has charged FCMs under Rule 2-23 only where it appears that the guarantor failed to diligently supervise its guaranteed IBs.
NFA has periodically provided Members with more guidance regarding their supervisory responsibilities by discussing the general issue in Notices to Members. NFA recognizes that, given the differences in the size of and complexity of the operations of NFA Members, there must be some degree of flexibility in determining what constitutes "diligent supervision" for each firm. It is NFA's policy to leave the exact form of supervision to the Member, thereby providing the Member with flexibility to design procedures that are tailored to the Member's own situation. Nevertheless, NFA's Board of Directors believes that it is appropriate to provide Members with specific minimum standards for a supervisory program for branch offices and guaranteed IBs ("remote locations") and therefore issues the following Interpretive Notice.
Though Members may tailor their supervisory procedures to meet their particular needs, any adequate program for supervision must include procedures for performing day-to-day monitoring and surveillance activities, conducting on-site visits of remote locations and conducting ongoing training for firm personnel. The firm's policies and procedures, including those for the supervision of branch offices and guaranteed IBs, should be in written form. Firm personnel and guaranteed IB personnel should be provided a copy of the appropriate policies and procedures relating to their duties, and be aware of the firm's requirements. A copy of all policies and procedures should be on file with the branch office or guaranteed IB. All supervisory personnel should be knowledgeable of the firm's requirements for supervision.
On a regular basis a Member should perform a number of supervisory procedures in order to monitor the business being conducted in its remote locations. The extent of the supervision depends on a number of factors, including the volume of trading, the experience of the personnel, the nature of the customers, the trading strategies followed by the office or certain APs, the number of customer complaints and the length of time that the office has conducted business with the firm. Repeated problems in any particular area should heighten the level of scrutiny and follow-up by the main office or guarantor.
The procedures to review the day-to-day activities of an office should include the following areas.
Hiring. An adequate program for supervision must include thorough screening procedures for prospective employees to ensure they are qualified and to determine the extent of supervision the person would require if hired. The appropriate documentation to support any yes answers on the Form 8-R should be obtained and reviewed for potential disqualifying information. Derogatory information, which the applicant may have submitted in connection with any past regulations, should be obtained from NFA.6 Prior employers should be contacted to confirm the person's previous work experience.
In connection with the review of the person's prior work experience, a prospective employer should check for any futures-related disciplinary proceedings against the person's prior employer.7 This information should be used by the prospective employer to determine the extent of supervision a particular applicant would require after he or she is hired.
Due Diligence Check of Guaranteed IBs. Guarantor FCMs must do a due diligence inquiry before entering into a guarantee agreement. The due diligence review must include a check to ensure that the IB is properly registered. The FCM's due diligence review should also include inquiries concerning the disciplinary history of the IB and the disciplinary and employment history of the IB's principals and APs. This type of information could be helpful to a prospective guarantor in determining the types of difficulties, if any, experienced by an IB, its principals and APs in the past and the extent of supervision which may be required of that IB under a guarantee agreement. For example, if the APs at a certain IB have received their futures training and experience at a firm or firms that have been subject to serious disciplinary actions by NFA or the CFTC, that IB may well require more supervision. Both registration and disciplinary information is readily available from NFA.8
Registration. Records of commissions payable to or generated by the branch office or guaranteed IB should be broken down by sales person and should be frequently reviewed to ensure that no commissions are being paid to unregistered individuals.
Customer Information. NFA Compliance Rules require each Member to adopt and enforce procedures regarding customer information and risk disclosure. The procedures for opening new accounts should require that the appropriate account documentation, including an acknowledgment of receipt of the required risk disclosure statement, be forwarded to the main office or guarantor.9 The documentation should be reviewed to ensure that the appropriate supervisory personnel approved the account. The information obtained from a customer should be reviewed to determine whether additional risk disclosure should have been provided to the customer. For any customer who should have received additional risk disclosure, the main office or guarantor should ensure that additional disclosure has been given and that such disclosure has been documented. It may also be necessary to contact the customer to verify that the disclosure was provided and that the customer understood its meaning. Notwithstanding these procedures, a firm may wish to require that all new account information and documentation be forwarded to the main office or guarantor for approval before trading commences in the account.
Account Activity. The trading activity in a customer and AP personal accounts should be reviewed and analyzed on a regular basis in order to highlight those accounts which may require further scrutiny. There are a number of calculations and comparisons which can be performed to flag accounts for follow-up or further monitoring. For example, significant losses, commission charges or number of trades should be reviewed for inappropriate trading strategies. The reason for error and correction entries to trading accounts should be investigated, especially if there appears to be a pattern of errors or corrections made by an office. Commission-to-equity ratios should be calculated for discretionary accounts to detect possible excessive trading. In order to identify improper trade allocations for discretionary accounts or front running, the trading results in an AP's personal account should be compared to the trading gains and losses in his or her customer accounts. Profitable customer accounts for a given AP should be reviewed for possible preferential treatment.
Appropriate supervisory personnel at the remote location should be notified of questionable account activity. Measures should be taken to follow up, such as reviewing order tickets and trade blotters, discussing the activity with the broker or contacting the customer.
Discretionary Accounts. NFA Compliance Rules 2-8 contains detailed requirements concerning the supervision and review of discretionary accounts. The written customer authorization and customer acknowledgment for third-party account controllers should be forwarded to the main office or guarantor.10 Confirmation of the registration history of APs of FCMs and IBs exercising discretion should be made to ensure that they have been properly registered for the requisite two-year minimum.
Promotional Material. NFA Members are required by rule to adopt and enforce procedures regarding communications with the public. All promotional material should be submitted by the branch office or guaranteed IB to the home office or guarantor for review and approval prior to its first use. Review and approval of the material should be documented by the appropriate supervisory personnel.
Customer Complaints. An adequate system for handling customer complaints should require that a written record of all complaints be maintained, and that complaints which meet certain criteria be sent to the main office or guarantor.11 Notification of the main office of customer complaints may be based on factors including the seriousness of the allegations of wrong-doing, the monetary amount involved, and which APs or principals are subjects of the complaints. If the remote location is responsible for resolving customer complaints, the home office or guarantor should also be notified of the outcome of resolved complaints. Notwithstanding these criteria, a firm may wish to consider having all customer complaints received by a remote location submitted to the main office.
The main office or guarantor should review the complaints for possible rule violations. It should also compare the allegations in the complaint for similarity to other complaints received against the same individuals or office. Such a review may detect a pattern of sales practice or other abuses.
The status of unresolved complaints should be periodically reviewed to ensure that the branch office or guaranteed IB has promptly responded to complainants.
In addition to day-to-day supervisory procedures, adequate supervision of the personnel who do work in the main office must also include periodic on-site inspections. As a general matter, NFA would expect these on-site inspections of guaranteed IBs or branch offices to be performed annually.
Members should develop written procedures for the on-site review process including detailed steps to be followed during the visit. This will help ensure that the review process is performed in a consistent manner and will not vary due to the involvement of different personnel in the review process. A Member's supervisory procedures should also address the number of visits to be made to a branch office or guaranteed IB. The frequency and nature of the visits, as well as whether the visit will be announced or unannounced, will depend on a number of factors including: the amount of business generated; the number of customer complaints received; the previous training and experience of the branch office personnel; and the frequency and nature of problems or concerns that arise as a result of day-to-day monitoring and surveillance of the office's activities. The personnel who make the visits should be qualified to perform examinations and knowledgeable of the industry and the nature of the firm's business. Such personnel should be able to perform their work with an independent, objective perspective.
The length of time between visits to the remote location coupled with the size and scope of its operation also plays a role in determining the procedures for on-site review of records and account documentation.12 In reviewing a smaller operation, it is feasible to conduct a comprehensive review of the remote location's records and documents over the entire time period between visits, while reviewing a larger scale operation may require the selection of a sample of records and documents for given time intervals. The selection of samples should be accomplished on a random basis, for example, selecting every third account for review for randomly selected time periods.
Promptly after the completion of an on-site visit, a written report should be prepared and its findings discussed with the branch office and regional managers or guaranteed IB's principals and supervisory personnel. Follow-up procedures should also be performed to ensure that any deficiencies revealed during an on-site visit are promptly corrected.
The written procedures for the on-site examination should include steps to review the following areas:
Customer Order Procedures. An on-site visit to a remote location should include a review of procedures for handling and recording customer orders. The individuals responsible for accepting customer orders should be identified and a sample of order tickets should be selected for review. NFA recommends that order tickets be prenumbered and that the on-site review test to ensure that all order tickets within the chosen samples are accounted for. The order ticket review should also confirm that all order tickets are properly time stamped and that all information required by CFTC Regulation 1.35 is included. If option orders are placed by the branch office or guaranteed IB, those order tickets should be reviewed to ensure that they contain the additional information required by CFTC Regulation 1.35. If a branch office or guaranteed IB handles discretionary option customer orders, a sample of these order tickets should be reviewed to confirm that the customer order is approved, initialed and dated by an officer or supervisory individual.
Discretionary Accounts. If a branch office or guaranteed IB handles discretionary accounts, the supervisory visit should confirm that the branch office or guaranteed IB identifies discretionary orders as such and that the firm's procedures regarding the supervision of discretionary trading activity are followed. In the event a branch office or guaranteed IB enters block orders, those orders should be reviewed to confirm that customer orders are not included with proprietary orders and that nondiscretionary customer orders are not included with discretionary customer orders. Split fills should be reviewed to ensure that they have been allocated according to established procedures.
If options are traded for discretionary accounts, the on-site visit should verify that the customer was provided with an explanation of the nature and risk of strategies to be used in trading the account, and that written approval by supervisory personnel was given prior to any options trading for the account.
Sales Practices. The on-site visit should include a review of sales solicitation practices as well as any promotional material utilized. A suggested starting point for review of the sales solicitation practices of a branch office or guaranteed IB is to identify the persons involved in sales solicitation and to confirm that they are properly registered. The individuals conducting the on-site review should also monitor sales solicitations while at the branch office or guaranteed IB. Interviews with selected customers should be conducted concerning the solicitation process and the handling of the customer's account. The individuals at the branch office or guaranteed IB responsible for supervising sales solicitations should be identified, and the method by which sales solicitations are supervised should be reviewed for adequacy.
The branch office or guaranteed IB's promotional material, including sales solicitation scripts, must be approved by appropriate supervisory personnel. Therefore, an on-site visit should be designed to ensure that the branch or guaranteed IB is not using any promotional material that has not received prior approval. If the main office or guarantor has not approved the promotional material, it should be reviewed during the on-site visit.
Customer Complaints. The on-site review should include steps to confirm that all complaints requiring notification have been reported to the main office.
Handling of Customer Funds. In order to assure that customer funds are being properly handled by a branch office, the on-site review should determine whether the branch office accepts funds from customers and, if so, whether appropriate bank accounts, including segregated accounts for customer funds, have been established by authorized personnel. In addition, for guaranteed IBs, the on-site review should confirm that if funds are accepted from customers, they are received in the name of the FCM. The branch office or guaranteed IB should make copies of any customer checks that they deposit into a qualifying or branch bank account. The check copies should be reviewed during the visit to ensure that the branch office or guaranteed IB only accepts checks made payable to the FCM. In addition, third-party checks should be scrutinized to ensure that no customers are acting as unregistered FCMs or CPOs. If the guaranteed IB received customer funds in the FCM's name, the review should confirm that the proper authorization to do so exists, that appropriate bank accounts are maintained and that proper procedures for forwarding the funds have been established and are followed. For both branch offices and guaranteed IBs, the flow of customer funds in a sample of accounts should be reviewed to determine that all funds have been timely transmitted and properly credited.
Proprietary Trading. To the extent feasible, there should be a separation of duties between persons handling customer orders and firm employees or principals trading for the firm's proprietary accounts or their own accounts to prevent misuse of non-public information or the occurrence of other trading abuses.
A Member's supervisory responsibilities include the obligation to ensure that its employees are properly trained to perform their duties. Procedures must be in place to ensure that employees receive adequate training to abide by industry rules and regulations and to properly handle customer accounts and that APs have completed the ethics training required by CFTC Regulation 3.34. Employees must be educated on developments and changes in the markets, futures products, rules and regulations, technology, and firm policies and procedures. The formality of a training program will depend on the size of the firm and the nature of its business. The individuals responsible for providing the training must be qualified to do so.
Certain APs may require training for soliciting and handling customer accounts. If an AP has previously worked at firms closed through an enforcement action for sales fraud and has therefore received his or her training from such firms, that AP may need specialized training in proper sales practices.
This Notice is intended to specify minimum supervisory standards for branch offices and guaranteed IBs. A failure to adhere to the requirements specified in this Notice will be deemed a violation of NFA Compliance Rule 2-9.
INTERPRETIVE NOTICE
COMPLIANCE RULE 2-9: SELF-AUDIT QUESTIONNAIRES
(Board of Directors, October 6, 1992)
NFA Compliance Rule 2-9 placed a continuing responsibility on every Member to diligently supervise its employees and agents in all aspects of their futures activities. NFA recognizes that, given the differences in the size and complexity of the operations of NFA Members, there must be some degree of flexibility in determining what constitutes "diligent supervision" for each firm. It is NFA's policy to leave the exact form of supervision up to the Member, thereby providing the Member with flexibility to design procedures that are tailored to the Member's own situation. The Board of Directors adheres to this principle but feels that all Members should regularly review the adequacy of their supervisory procedures.
The Board of Directors has determined that in order to satisfy their continuing supervisory responsibilities, NFA Members must review on a yearly basis self-audit questionnaires to be distributed by NFA's Compliance Department that can be downloaded from NFA's web site at www.nfa.futures.org. The questionnaires must be reviewed by the appropriate supervisory personnel in either the home or branch office. After reviewing the questionnaire, the appropriate supervisory person must sign the questionnaire stating that the Member's operations have been evaluated based on the questionnaire and attesting that the Member's procedures comply with all applicable NFA requirements.
Members are required to retain the signed questionnaire in their files for a period of five years from the date of review, with the questionnaires being readily accessible during the first two years. In addition, guaranteed IBs must provide and guarantor FCMs must obtain copies of the signed questionnaires. Members must also provide the signed questionnaires for inspection upon request by NFA.
Review of the questionnaires should aid Members in recognizing potential problem areas and alert them to procedures which need to be revised or strengthened. The questionnaires focus on a Member's regulatory responsibilities and require a review of the adequacy of the Member's internal procedures. For example, the FCM questionnaire requires review of a Member's procedures relating to customer order flow, customer account documentation, risk disclosure, margin policies, option accounts and transactions, customer complaints, advertising, cash flow and compliance with NFA requirements. Similarly, the CPO/CTA questionnaires contain a checklist which will assist CPOs and CTAs in their review of disclosure documents. A Member firm that does not comply with this Interpretive Notice will violate NFA Compliance Rule 2-9.
Questions regarding this Interpretation or the questionnaires should be directed to the Compliance Department at 800-621-3570 or through the "contact" feature of NFA's web site.
[NOTE: The self-audit questionnaire is now called the "Self-Examination Checklist."]
COMPLIANCE RULE 2-13: BREAK-EVEN ANALYSIS
(Board of Directors, August 24, 1995)
NFA Compliance Rule 2-13 requires, in pertinent part, that each Member CPO which delivers a disclosure document under the CFTC Regulation 4.21 must include in the disclosure document a break-even analysis which includes a tabular presentation of fees and expenses. The break-even analysis must be presented in the manner prescribed by NFA's Board of Directors. The purpose of this requirement is to ensure not only that customers will be clearly informed as to the nature and amount of fees and expenses that will be incurred, but that customers will also be made aware of the impact of those fees and expenses on the potential profitability of their investments. NFA's Board of Directors has adopted the following guidelines which must be adhered to by NFA Member CPOs when preparing the break-even analysis required by Compliance Rule 2-13:
- If fees are likely to be affected by the size of the offering, then an assumed amount of total funds raised should be stated. The document should also state what the break-even point would be if the minimum or maximum proceeds were raised.
- If there are redemption fees, they must be clearly shown and considered part of the total cost and reflected in the break-even analysis.
- Incentive fees should be stated as a percentage of profits, and the method by which profits are calculated should be described.
- All management, brokerage and other fees should reflect actual experience or contractual charges, if known. If not known, they should be based on good faith estimates. If, for example, CTAs publish their estimated number of round turns/$1,000,000 then those published estimates should be used for estimating brokerage costs. If this is an on-going fund or if there is evidence supporting other numbers, then the other numbers should be used and explained.
- If pool participants are to receive some or all of the interest income generated by the pool, the expected interest income should be deducted from the expenses which must be covered by trading profits to return the customer to the level of his initial investment. The estimate of that interest income must include the assumed interest rate, and that rate must reflect current cash market information. If any interest income is to be paid to the pool operator, or to anyone other than the pool participants, that fact and an estimate of the amount must also be clearly disclosed.
To calculate the break-even point a CPO must first determine the amounts of all fees and expenses, exclusive of incentive fees, that are anticipated to be incurred by the pool during the first year of the investment. The total of these fees and expenses less the amount of interest income expected to be earned by the pool represents the gross trading profits before incentive fees (preliminary gross trading profits) that would be necessary for the pool to retain its initial Net Asset Value per unit at the end of the first year. In some situations the CPO must then calculate the additional trading profit that would be necessary to overcome the incentive fees that would be incurred. This situation will arise whenever the pool expects to incur expenses which would not be deducted from the CTA's net performance in calculating the CTA's incentive fee. That amount can be computed by first determining the incentive fees that would be incurred if the preliminary gross trading profits described above were achieved and then dividing that amount by (1 - incentive fee rate); e.g., if the incentive fee is 25 percent, the denominator would be 1 - .25, or .75). A sample break-even presentation is shown below:
| Selling Price per Unit (1) | $1,000.00 |
| Syndication and Selling Expense (1) | $ 50.00 |
| General Partner's Management Fee (2) | $ 9.50 |
| Fund Operating Expenses (3) | $ 20.50 |
| Trading Advisor's and Trading Manager's Management Fees (4) | $ 28.50 |
|
Trading Advisor's and Trading Manager's
Incentive Fees on Trading Profits (5) |
$ 17.17 |
| Brokerage Commissions and Trading Fees (6) | $ 38.00 |
| Less Interest Income (7) | $ (28.50) |
| Amount of Trading Income Required for the Fund's Net Asset Value per Unit (Redemption Value) at the End of One Year to Equal the Selling Price per Unit |
$ 135.17 |
| Percentage of Initial Selling Price per Unit | 13.52% |
- Explanatory Notes:
(1) Investors will initially purchase units at $1,000. After the commencement of trading, units will be purchased at the Fund's month-end Net Asset Value per unit. A five percent syndication and selling charge will be deducted from each subscription to reimburse the Fund, the General Partner and/or the Clearing Broker for the syndication and selling expenses incurred on behalf of the Fund.
(2) Except as set forth in these explanatory notes, the illustration is predicated on the specific rates or fees contracted by the Fund with the General Partner, the Trading Manager, the Trading Advisor, and the Clearing Broker, as described in "Fees, Compensation and Expenses."
(3) The Fund's actual accounting, auditing, legal and other operating expenses will be borne by the Fund. These expenses are expected to amount to approximately 2.05 percent of the Fund's Net Asset Value.
(4) The Fund's Trading Advisor will be paid a monthly management fee of 1/12 of two percent of Allocated Net Assets. The Fund's Trading Manager will be paid a monthly management fee of 1/12 of one percent of allocated Net Assets.
(5) The Trading Advisor and Trading Manager will receive incentive fees of 20 percent and five percent, respectively, of Trading Profits exclusive of interest income. The $17.17 of incentive fees shown above is equal to 25 percent of the net of total trading income of $135.17, minus $38.00 of brokerage commissions and trading fees and $28.50 of management fees.
(6) Brokerage commissions and trading fees are estimated at four percent of Net Asset Value.
(7) The fund will earn interest on margin deposits with its Clearing Broker. Based on current interest rates, interest income is estimated at three percent of Net Asset Value.
NFA FINANCIAL REQUIREMENTS:
THE ELECTRONIC FILING OF FINANCIAL REPORTS
(Board of Directors, March 24, 1997)
NFA Financial Requirements require each FCM for which NFA is DSRO and each IB which is not operating pursuant to a guarantee agreement to file financial reports with NFA. FCMs must file reports at least quarterly while IBs file on a semi-annual basis. FCMs file reports on CFTC Form 1-FR-FCM while IBs use Form 1-FR-IB. FCMs or IBs which are also registered as securities brokers or dealers may use the SEC FOCUS Report in lieu of the Form 1-FR for their financial reports.
The filing requirements are discussed in Schedule D of NFA Financial Requirements for FCMs and in Section 10 of the Financial Requirements for IBs. These rules cover the contents of the financial reports and the time periods in which the reports must be filed. Additionally, CFTC regulations require that any financial report filed by an FCM or IB with NFA must also be filed with the CFTC.
NFA has developed personal computer software which allows FCMs and IBs to electronically file financial reports with NFA and the CFTC. The software accommodates filing of the Form 1-FR-FCM, Form 1-FR-IB and the FOCUS Report. NFA's Board of Directors has determined that the electronic filing of financial reports will satisfy the filing requirements for FCMs and IBs set forth in NFA Financial Requirements. All other filing-related requirements, such as deadlines for filing and the contents of the reports, remain unchanged. These requirements are not affected by the manner of filing.
NFA's filing software will also includes procedures for the appropriate representative of the NFA Member FCM or IB to attest to the completeness and accuracy of the financial report in order to comply with NFA and CFTC certification and attestation requirements.
Full details about the software and electronic filing procedures are available by accessing the Member Compliance Section, Issues for FCMs and IBs, of NFA's web site at http://www.nfa.futures.org or by contacting the Information Center at (312) 781-1410.
Finally, while all Member FCMs and IBs are encouraged to file financial reports electronically, electronic filing of financial reports is not required. Member FCMs and IBs may continue to file hardcopy financial reports as they have in the past in accordance with NFA Financial Requirements.
FCM AND IB FILING REQUIREMENTS
(Board of Directors, June 3, 1997)
Effective June 30, 1997, NFA Financial Requirements call for any unaudited financial report filed by an FCM or an IB not operating pursuant to a guarantee agreement to be filed with NFA within 17 business days. In order for FCMs and IBs to become acclimated to the new filing deadlines, the due dates for all unaudited financial reports as of a date of June 30, 1997 through December 31, 1997 will be 30 days after the date of the statement instead of the 17 business days. Beginning with unaudited statements dated in 1998 the 17 business day requirement will apply.
NFA Compliance Rules and Interpretive Notices
The proposed amendments to NFA Compliance Rules and Interpretive Notices to Compliance Rules are technical in nature and fall into five general categories. In particular, the proposed amendments either:
- Specifically prohibit conduct that violates NFA Compliance Rule 2-4, which requires Members and Associates to observe high standards of commercial honor and just and equitable principles of trade;
- Eliminate duplicative and unnecessary requirements, including rules that relate only to options;
- Update references to NFA rules and CFTC regulations based on subsequent changes to those rules or regulations;
- Conform NFA recordkeeping requirements to CFTC recordkeeping requirements; or
- Clarify the meaning of a rule or make it internally consistent.
Compliance Rule 1-1. This is the definition section of the Compliance Rules. The proposed changes either clarify specific definitions, add definitions for terms that are frequently used in the Compliance Rules (e.g., commodity pool operator and commodity trading advisor), or make the definition section internally consistent. None of the proposed changes are substantive.
Compliance Rule 2-2. NFA has taken several disciplinary actions against Members or Associates who were acting in a different capacity than the one they were registered in (e.g., a CTA accepting and pooling customer funds, thereby acting as a CPO). NFA charged those persons with violating Compliance Rule 2-4, Conduct Inconsistent with Just and Equitable Principles of Trade, because there is no specific prohibition in the rules. This conduct has occurred often enough to warrant that the prohibition be codified.
Compliance Rule 2-5. The change specifically prohibits Members and Associates from violating an order issued by an NFA committee or panel that has authority to issue orders. This is another type of conduct that currently results in a charge under Compliance Rule 2-4 and should be codified.
Compliance Rule 2-8. The primary change to subsection (b) eliminates the word "conclusively" to describe the presumption that discretion was used, thereby conforming it to subsequent changes to exchange rules by making the presumption rebuttable. Subsection (c) does not cover any activity that is not already covered by Compliance Rule 2-9, Supervision, so it should be eliminated. The other changes merely clarify the meaning of the rule.
Compliance Rules 2-11 and 2-12. Compliance Rule 2-11 provides a process for an FCM to obtain NFA's approval before carrying customer accounts. Compliance Rule 2-12 provides for both the omnibus FCM and the carrying FCM to notify NFA whenever an omnibus account is opened or closed. In practice, both of these requirements have proven to be administratively unwieldy and unnecessary. On the few occasions when NFA needed to know where a firm's omnibus accounts are carried, NFA was able to obtain the information by asking the firm or reviewing its books. Requiring firms to obtain NFA's permission before carrying customer funds is also unnecessary and has been replaced with a notice requirement. If NFA has concerns, it will still be able to work with the firm to resolve those concerns or, in an extreme case, to issue a Member Responsibility Action prohibiting the FCM from carrying customer accounts.
Compliance Rule 2-13. Compliance Rule 2-13 makes it a violation of NFA rules for a Member CPO or CTA to violate any of several CFTC Regulations specified in the rule and requires them to file copies of notices with NFA when they file those notices with the Commission. The proposed amendment incorporates regulations that were subsequently adopted or amended by the Commission. It also clarifies that the break-even analysis must be current as of the date of the disclosure document.
Compliance Rule 2-14. This is a technical amendment to remove what is now an incorrect reference.
Compliance Rules 2-15 through 2-18. These rules deal only with options transactions. They were adopted when exchange-traded options were first authorized as part of a pilot program and were intended to comply with CFTC Regulations in effect at that time. However, both subsequent amendments to those regulations and the existence of nearly identical NFA requirements covering both futures and options (i.e., Compliance Rules 2-9, 2-10, and 2-29) make these rules unnecessary.
Compliance Rule 2-26. Compliance Rule 2-26 makes it a violation of NFA rules for a Member FCM or IB to violate any of several CFTC Regulations specified in the rule. The Commission has since adopted CFTC Regulation 1.65 regarding bulk transfers. The proposed amendment adds that regulation to those specified in Compliance Rule 2-26.
Compliance Rule 2-29(c). The interpretive notice on hypothetical results, which is incorporated into Compliance Rule 2-29(c) by reference, specifically states that no Member or Associate may use hypothetical results for any program with three months of actual trading results. The Board felt that this requirement is important enough that it should be stated in the rule itself.
Compliance Rule 2-29(f). The amendments change the retention period to conform to CFTC Regulation 1.31. In addition, the last sentence of Subsection (f) requires Members to demonstrate the basis for hypothetical results to NFA upon request. The proposed amendment extends that requirement to actual results as well and specifically provides that Members must retain records to support those results.
Compliance Rule 2-29(h). Subsection (h) is amended to clarify that "futures account, agreement, or transaction" includes commodity pool participations, managed account services, and non-personalized trading advice.
Interpretive Notice on Communications with the Public and Promotional Material. This Interpretive Notice was adopted at the same time as Compliance Rule 2-29 and is frequently referred to by both NFA and NFA Members. Therefore, the Board felt that it is important to preserve the nature of this Notice and to make the minimum changes necessary to conform it to subsequent rule changes. The principal change is to eliminate a discussion of hypothetical results that is no longer correct in light of subsequent changes to Compliance Rule 2-29. The remaining changes are purely technical.
Interpretive Notice on Disclosure by FCMs and IBs of Costs Associated with Futures Transactions. This Interpretive Notice requires FCMs and IBs to disclose detailed information to individual customers regarding fees that are based on anything other than a traditional commission. Obviously, all fees and charges should be disclosed to customers. However, the Board felt that the extensive information required by the Notice is not helpful to customers and imposes an unnecessary burden on FCMs and IBs. The proposed amendments retain the requirement that FCMs and IBs disclose the basis for their fees but eliminates the excessive detail currently required by the Notice.
Interpretive Notice on Supervision of Branch Offices and Guaranteed IBs. Over the years, NFA staff has issued a number of notices on supervision of branch offices and guaranteed IBs. In 1992, the Board adopted this Interpretive Notice, which contains most of the information from the previous staff notices. However, the staff notices continue to be printed in NFA's rulebook. The Board felt that the duplicative notices issued by staff should be eliminated. The minor changes to the Interpretive Notice incorporate the few non-duplicative provisions of the staff notices and update the Interpretive Notice to reflect subsequent changes to NFA rules.
Interpretive Notice on Self-Audit Questionnaires. The amendment to this Interpretive Notice informs Members that the self-examination checklist can be downloaded from NFA's web site.
Interpretive Notice on Break-Even Analyses. A staff Notice addressed the same subject as this Interpretive Notice. The non-duplicative information from the staff Notice was added to this Interpretive Notice, thus allowing for the deletion of the staff Notice.
Interpretive Notice on the Electronic Filing of Financial Reports. The proposed amendments to this Interpretive Notice deletes references to sections of NFA's Financial Requirements that were recently eliminated.
Interpretive Notice on FCM and IB Filing Requirements. This Interpretive Notice advised Members of the number of days they had to file financial requirements during a transitional period that has since expired. The Interpretive Notice is no longer necessary and should be eliminated.
1Article XVIII(k) of NFA's Articles of Incorporation defines futures to include "options contracts traded on a contract market, and such other commodity-related instruments as the Board may from time to time declare by Bylaw to be properly the subject of NFA regulation and oversight." Currently, the only NFA Bylaw expanding that definition is Bylaw 1507, which states that "'futures' as used in these Bylaws shall include option contracts granted by a person that has registered with the Commission under Section 4c(d) of the Act as a grantor of such option contracts or has notified the Commission under the Commission's rules that it is qualified to grant such option contracts." [Bylaw 1507 has since been amended to include foreign futures and options contracts and leverage transactions.]
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2However, it must be noted that much, if not all, of the benefits to customers of the disclosures and cautionary statements required to be included in promotional material by other sections of Rule 2-29 and other disclosure statements required by CFTC and NFA Rules (e.g., the risk disclosure statements required by CFTC Rule 1.55 and NFA Compliance Rule 2-27) can be intentionally diminished in the course of oral communications with customers. To avoid that result it is expected that Business Conduct Committees will presume intentional or reckless deceit in instances where a Member or Associate specifically contradicts or downplays any disclosure statement required to be made by CFTC or NFA rules.
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3CPOs and CTAs are, however, subject to such a requirement through the CFTC's Part 4 Rules.
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4 The Committee expects that a Member or Associate could exclude from "reasonably comparable accounts" those that were actually traded pursuant to a different trading strategy or those that were traded independently of the accounts in the program for which performance is cited. With respect to the question of independence the indicia of independence listed in the CFTC's statement of policy concerning when accounts should be aggregated for position limit purposes would be useful guides for Members, Associates and Business Conduct Committees. Statement of Aggregation Policy (1977-80 Transfer Binder) Comm. Fut. L. Rep. (CCH) 20,837 (June 13, 1979); 44 Fed. Reg. 33839.
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5NFA Bylaws defined "futures" to include
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6The detailed explanation of any "yes" answers on an 8-R is treated as nonpublic information; however, it is available to prospective employers under NFA Registration Rule 701(c). See Interpretive Notice at ¶ 9010.
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7Information concerning futures-related disciplinary proceedings can be obtained
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8Registration information is also available by checking the BASIC system on NFA's web site at www.nfa.futures.org, sending a request to NFA through the "contact" feature of the web site, or calling NFA's Information Center at 800-621-3570. See Interpretive Notice at ¶ 9007.
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9NFA Rules require that a guaranteed IB maintain a record of the information obtained from a customer and a copy of the risk disclosure acknowledgment. A branch office may wish to keep copies of this information for its files.
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10NFA Rules require that a guaranteed IB maintain a record of the written customer authorization and customer acknowledgments for third-party account controllers. A branch office may wish to keep copies of this information for its files.
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12If a visit is prompted by awareness of a particular problem at a remote location or if a problem is discovered during a routine visit, the Member must ensure that the scope of the review is adequate to thoroughly examine the problem area.
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