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9021 - NFA COMPLIANCE RULES 2-9 and 2-36: ENHANCED SUPERVISORY REQUIREMENTS FOR FCMs, IBs, FDMs, CPOs AND CTAs(Board of Directors, January 19, 1993; revised August 14, 1996, December 16, 1996; March 10, 1998; July 1, 2000; January 1, 2001; June 1, 2001; August 21, 2001; March 18, 2003; November 9, 2004; February 15, 2006; April 15, 2006; November 1, 2007; December 17, 2007; September 18, 2008; January 3, 2011; October 1, 2014; June 13, 2016; September 19, 2016; January 31, 2018; and September 30, 2019.)
Over the years, NFA's Board of Directors has adopted strict and effective rules to prohibit deceptive sales practices, and those rules have been vigorously enforced by NFA's Business Conduct Committee. The Board notes, however, that by their very nature, enforcement actions occur after the customer abuse has taken place. The Board recognizes that NFA's goal must be not only to punish such deception of customers through enforcement actions but to prevent it, or minimize its likelihood, through fair and effective regulation.
One NFA rule designed to prevent abusive sales practices is NFA Compliance Rule 2-9. Subsection (a) of this rule places a continuing responsibility on every FCM, IB, CPO and CTA Member to diligently supervise its employees and agents in all aspects of their commodity interest activities, including sales practices. Although NFA has not attempted to prescribe a set of supervisory requirements to be followed by such Members, NFA's Board of Directors believes that Member firms that are identified as having a sales force and/or principals that have been affected by questionable sales practice training and firms that charge commissions, mark-ups, fees and other charges well above the industry norm should be required to adopt enhanced supervisory requirements designed to prevent sales practice abuse. NFA Compliance Rule 2-36(e) imposes similar supervisory requirements on forex activities of FDMs. NFA Compliance Rules 2-9(b) and 2-36(e)(2) authorize the Board of Directors to require FCM, IB, CPO and CTA Members and FDMs, which meet certain criteria established by the Board, to adopt specific supervisory procedures designed to prevent abusive sales practices.
The Board believes that in order for the criteria used to identify firms subject to the enhanced supervisory requirements to be useful, those criteria must be specific, objective and readily measurable. The Board also believes that any supervisory requirements imposed on an FCM, IB, CPO or CTA Member or an FDM must be designed to quickly identify potential problem areas so that the Member will be able to take corrective action before any customer abuse occurs. The purpose of this Interpretive Notice is to set forth the criteria established by the Board that obligate a Member to adopt the enhanced supervisory requirements and to specify the enhanced supervisory requirements that are required of firms meeting these criteria.
In developing the criteria, the Board concluded that it would be helpful to review Member firms that had been disciplined through enforcement actions taken by the CFTC or NFA for deceptive sales practices. The Board's purpose was to identify factors common to these Member firms and probative of their sales practice problems, which could be used to identify other Member firms with potential sales practice problems.
One factor identified by the Board as common to these firms and directly related to their sales practice problems is the employment history and training of their APs and principals. For many of these Members, a significant portion of these individuals were previously employed and trained by one or more Member firms which had been disciplined for fraud. The Board believes that the employment history of a Member's APs and principals is a relevant factor to consider in identifying firms with potential sales practice problems. If a Member firm is disciplined by NFA or the CFTC for fraud related to widespread sales practice or promotional material problems or by the Financial Industry Regulatory Authority or the SEC for fraud related to its sales practices regarding security futures products as defined in Section 1a(45) of the Commodity Exchange Act ("Act"), it is reasonable to conclude that the training and supervision of its sales force was wholly inadequate or inappropriate. It is also reasonable to conclude that an AP or principal who received inadequate or inappropriate training and supervision may have learned improper sales tactics, which he will carry with him to his next job. Therefore, the Board believes that a Member firm employing such a sales force must have stringent supervisory procedures in place in order to ensure that the improper training its APs and principals have previously received does not taint their sales efforts on behalf of the Member.
The Board notes further that there have been instances in which Members and Associates have subverted the Board's purpose in imposing the enhanced supervisory requirements by closing a firm once it qualifies for those requirements and opening another firm or firms that have a mix of employees that does not meet the criteria for adopting the requirements. The new firms typically have individuals who have worked for firms that have been disciplined for fraud related to sales practices or promotional material and who worked at the original qualifying firm, but they are redistributed so as to keep the employee mix below the threshold for becoming subject to the enhanced supervisory requirements. The Board has determined to apply the enhanced supervisory requirements to firms that use this strategy.
The Board also notes that Members that assess commissions, mark-ups, fees and other charges that total well above the industry norm comprise a disproportionately high share of firms that have been subject to disciplinary action for sales practice abuses. Some of the abuses that have been cited relate to the creation of a misleading impression of the likelihood of achieving profits by investing with a Member through misstatements or material omissions concerning the impact of commissions, mark-ups, fees and other charges.
The Board believes that when an FCM, IB, CPO or CTA Member or an FDM charges its customers commissions, mark-ups, fees and other charges that total well above the industry norm it is incumbent on that Member to exercise a very high degree of supervision of solicitations made by its APs so as to ensure that customers are given accurate information regarding the impact of those expenses on the likelihood of achieving profit. Consistent with its approach in other situations involving an increased likelihood of misleading solicitations, the Board believes that the enhanced supervisory requirements provide a practical opportunity for a Member that charges commissions, mark-ups, fees and other charges that are well above the industry norm to monitor solicitations and correct problems with those solicitations in an expeditious manner.
II. OBLIGATIONS OF MEMBERS SUBJECT TO THE ENHANCED SUPERVISORY REQUIREMENTS
A. Recording of all conversations and maintaining electronic written communications with existing and potential customers
Those FCM, IB, CPO and CTA Members and FDMs meeting the criteria requiring them to adopt the enhanced supervisory requirements will be required to make complete audio recordings of all telephone conversations that occur between their APs and both existing and potential customers, including existing and potential retail forex customers of Members subject to NFA Compliance Rule 2-36. Additionally, those FCM, IB, CPO and CTA Members and FDMs will be required to maintain a record of all electronic written communications that occur between their APs and customers or potential customers. Electronic written communications include, but are not limited to, email, text messages, instant messages conducted via any web-based messaging system (including instant messages sent via a social media application), and any other communication that occurs in a chat room or on any social media platform. The Board believes that recording these conversations and requiring FCM, IB, CPO and CTA Members and FDMs to maintain records of electronic written communications provides these Members with the best opportunity to monitor closely the activities of their APs and also provides these Members with complete and immediate feedback on each AP's method of soliciting customers. Members subject to the enhanced supervisory requirements must retain such audio recordings and records of electronic written communications for a period of five years from the date each recording is created or written electronic communication occurs and the recordings and/or records of electronic written communications shall be readily accessible during the first two years of the five-year period. In retaining the recorded conversations or records of electronic written communications, Member firms must catalog the recordings and electronic written communications by AP and date. Additionally, any Member firm meeting the criteria must require all its APs to maintain a daily log for sales solicitations which reflects at a minimum the identity of each customer or prospective customer the AP spoke with or transmitted electronic written communications to on each day and the method of communication. A Member firm must be able to promptly produce, upon request from NFA or the CFTC, all conversations or records of electronic written communications relating to a specific AP, and only that AP, for a given date. Members that are required to record or maintain records of electronic communications under this Interpretive Notice are further required to promptly provide NFA or the CFTC with appropriate resources for listening to their recordings or viewing the records of electronic communications upon request.
B. Enhanced capital requirement
Any Member introducing broker ("IB") meeting the criteria is required to either operate pursuant to a guarantee agreement or maintain adjusted net capital of at least $250,000 during the entire period for which the Member is required to adopt the enhanced supervisory requirements. Eligible guarantor futures commission merchants ("FCM"s) are those that meet the eligibility requirements for executing a Supplemental Guarantor Certification Statement pursuant to NFA Registration Rule 509(b)(5). Any IB Member opting to maintain the higher level of adjusted net capital shall also be subject to the financial record-keeping and reporting requirements applicable to FCMs.
Any Member commodity trading advisor ("CTA") or commodity pool operator ("CPO") meeting the criteria is required to maintain adjusted net capital of at least $100,000 during the entire period for which the Member is required to adopt the enhanced supervisory requirements. Member CTAs and CPOs meeting the criteria are required to demonstrate compliance with this adjusted net capital requirement to NFA upon request.
Any Forex Dealer Member ("FDM") or FCM meeting the criteria is required to maintain adjusted net capital of at least the early warning requirement under CFTC rules.
C. Filing promotional material with NFA
Those Member firms meeting the criteria will be required to file all promotional material, as defined in NFA Compliance Rule 2-29(i), with NFA at least 10 days prior to its first use.
D. Written supervisory proceduresThose FCM, IB, CPO and CTA Members and FDMs meeting the criteria shall have written supervisory procedures that include the titles, registration status and locations of the firm's supervisory personnel as these relate to the firm's commodity interest business and applicable securities laws and regulations for the trading of security futures products. The written procedures must include at a minimum:
- a description of the steps taken to supervise and monitor calls which identify how often monitoring of recordings will take place; who will conduct the monitoring; and how the results of monitoring will be documented;
- specific information identifying the recording equipment being used;
- a description of the steps taken to supervise and monitor APs' electronic written communications with customers which identify how the Member will monitor them, how often the Member will monitor them, who will conduct the monitoring and how the results of that monitoring will be documented;
- a description of the method for cataloging and maintaining recordings and written electronic communications; and
- a description and sample format of the daily logs prepared by APs that includes, at a minimum, the identity of each customer or prospective customer the AP spoke or transmitted an electronic written communication with on each day and the method of communication.
Member firms shall also maintain on an internal record the names of all persons who are designated as supervisory personnel and the dates for which the designation is or was effective. Additionally, a Member meeting the criteria shall file with NFA's Compliance Department a report relating to the Member firm's compliance with the supervisory requirements contained herein within 15 days after the end of each calendar quarter. Member firms shall retain the internal record and report(s) for a period of five years, the first two years in an easily accessible place.
III. QUALIFICATION FOR THE ENHANCED SUPERVISORY REQUIREMENTS
A. Definitions, treatment of individuals and firms and exemptions
1. Definition of Disciplined Firm
A current list of the firms that meet the definition of a Disciplined Firm is maintained on NFA's Web site at https://www.nfa.futures.org/ereg. For purposes of this Interpretive Notice, a Disciplined Firm is defined very narrowly to include those firms that fall into one of the following two groups:
- a. Firms that have been disciplined by NFA or the CFTC
Members that qualify as Disciplined Firms based on their disciplinary histories with the CFTC or NFA include those firms for which:
1. the firm has been formally charged by either the CFTC or NFA with deceptive sales practices or promotional material;
2. those charges have been resolved; and
3. the firm has either been permanently barred from the industry at any time as a result of those charges or has been sanctioned in any way within the preceding five years as a result of those charges.
Members that qualify as Disciplined Firms based on their disciplinary histories related to sales practices involving security futures products include any broker-dealer that, in connection with sales practices involving the offer, purchase, or sale of any security futures product as defined in Section 1a (45) of the Act has at any time been expelled from membership or participation in any securities industry self-regulatory organization ("Securities SRO") or is subject to an order of the SEC revoking its registration as a broker-dealer or has been sanctioned in any way within the preceding five years in connection with sales practices involving the offer, purchase, or sale of any security futures product as defined in Section 1a (45) of the Act.
2. Treatment of principals who previously worked at a Disciplined Firm
For purposes of determining whether a Member will be required to adopt the enhanced supervisory requirements based on the employment histories of its APs and principals, principals of a firm, who are not also APs of that firm and who have been previously employed as an AP by one or more Disciplined Firms, shall be counted as if they were APs of the firm.
3. Treatment of FCMs and FDMs that guarantee introducing brokers
For purposes of determining whether an FCM Member or an FDM will be required to adopt the enhanced supervisory requirements, an FCM or FDM and its guaranteed introducing brokers ("GIBs") will be considered a single firm. Therefore, for FCMs and FDMs with GIBs, the APs of its GIBs will be treated as APs of the FCM or FDM for determining whether the FCM or FDM meets the requirements. If the FCM or FDM meets the requirements, then the FCM or FDM and all its GIBs shall be required to adopt the supervisory procedures specified herein. Of course, individual FCMs, FDMs or GIBs will be required to adopt the enhanced supervisory requirements provided the FCM, FDM or GIB meets the requirements on its own.
4. Exemptions from being counted as an AP who worked at a Disciplined Firm
The Board recognizes that there are identifiable populations of APs who are included in the general population of APs who have worked at Disciplined Firms in the past who, further analysis suggests, do not raise the same concerns regarding their previous supervision and training that are raised by the majority of APs who have worked at Disciplined Firms. Generally, these APs worked at Disciplined Firms fairly long ago and are free of additional factors of concern in their employment histories.
A number of the APs in this group worked at Disciplined Firms for only a short period of time many years ago and have not worked at a Disciplined Firm since or been personally subject to disciplinary action. Others worked at a single Disciplined Firm for a somewhat lengthier period and have subsequently been employed for a substantial length of time by Members that have not shown a propensity for customer abuse and the AP has not been personally subject to disciplinary action.
The Board has determined that APs who have not been personally subject to a disciplinary action by NFA or the CFTC and who meet the following criteria shall not be counted by a Member that hires them as having been employed by a Disciplined Firm for purposes of calculating whether the composition of the Member's sales force triggers the enhanced supervisory requirements:
a. they have been previously employed by Disciplined Firms for a cumulative total of less than 60 days and have not been employed by any Disciplined Firm during the 5 years preceding the determination of whether a Member firm is required to employ the enhanced supervisory requirements established in this Interpretive Notice. In addition, the AP may not have been employed by a Member that has been subject to any sales practice action by NFA or the CFTC, or by any Securities SRO or the SEC in connection with sales practices involving the offer, purchase or sale of any security futures product as defined in Section 1a (45) of the Act since leaving the last Disciplined Firm by which they were employed; or
b. they worked at only one Disciplined Firm more than 10 years preceding the determination of whether a Member firm is required to employ the enhanced supervisory requirements and they have not been employed by a Member that has been subject to any sales practice action by NFA or the CFTC, or by any Securities SRO or the SEC in connection with sales practices involving the offer, purchase or sale of any security futures product as defined in Section 1a (45) of the Act within the 10 years preceding the determination, and they have been an NFA Member or Associate Member for at least eight of the ten years preceding the determination.
B. Criteria that obligate an FCM, IB, CPO or CTA Member or an FDM to adopt the enhanced supervisory requirements
FCM, IB, CPO and CTA Members and FDMs will be required to adopt the enhanced supervisory requirements if they fall into any of the categories described below.
1. Obligation based on employment histories of APs and principals
FCM, IB, CPO and CTA Members and FDMs that meet any of the following numerical criteria are required to adopt the enhanced supervisory requirements:
- For firms with less than five APs, 2 or more of its APs have been employed by one or more current Disciplined Firms;
- For firms with at least 5 but less than 10 APs, 40 percent or more of its APs have been employed by one or more current Disciplined Firms;
- For firms with at least 10 but less than 20 APs, four or more of its APs have been employed by one or more current Disciplined Firms; or
- For firms with at least 20 APs, 20 percent or more of its APs have been employed by one or more current Disciplined Firms.1
2. Obligation based on affiliations of principals
Once an FCM, IB, CPO or CTA Member or an FDM meets the criteria to adopt the enhanced supervisory requirements, any other Members of which the principals of that Member firm are, or become, principals must also adopt the enhanced supervisory requirements or seek a waiver therefrom subject to the following exception.
As is the case with some APs, the Board recognizes that there is a limited group of individuals who have been principals of firms that have qualified for the enhanced supervisory requirements who are otherwise free of additional factors that raise concern about their ability to effectively supervise their firms. Therefore, an FCM, IB, CPO or CTA Member or an FDM will not qualify for the enhanced supervisory requirements under this section if the principal whose history would cause the qualification meets the following criteria:
- the principal has not been personally subject to a disciplinary action by NFA or the CFTC;
- the principal has never been a principal or an AP of a current Disciplined Firm;
- the most recent firm in the principal's history that qualified for the enhanced supervisory requirements either received a full waiver from abiding by those requirements or abided by those requirements for at least two years and is no longer subject to the enhanced supervisory requirements; and
- no firm in the principal's history that qualified for the enhanced supervisory requirements has become subject to a sales practice or promotional material based disciplinary action by NFA or the CFTC since qualifying for the enhanced supervisory requirements.
3. Obligation based on assessing commissions, mark-ups, fees and other charges well above the industry norm
Any FCM, IB, CPO and CTA Member or FDM that charges 50% or more of its active customers round-turn commissions, mark-ups, fees and other charges that total $100 or more per futures, forex or option contract or cleared swap is required to adopt the enhanced supervisory requirements. Any FCM, IB, CPO or CTA Member or FDM that charges 50% or more of its active customers round-turn commissions, mark-ups, fees and other charges in the amount specified above must promptly inform NFA of that fact. In addition, upon request by NFA, Members shall have the burden of demonstrating to NFA that they charge more than 50% of their active customers round-turn commissions, mark-ups, fees and other charges that are less than the specified amounts. The term "active customers" as used in this section means any customers who are entitled to a monthly statement under the provisions of CFTC Regulations Section 1.33(a). For purposes of this section, any Member whose customer initiates an options contract that would result in total commissions, mark-ups, fees and other charges of $100 or more if the trade was liquidated will be deemed to have charged total commissions, mark-ups, fees and other charges of $100 even if the contract is not ultimately liquidated.
4. Obligation based on the initiation of disciplinary action
- a. Members that have fulfilled the enhanced supervisory requirements that become subject to subsequent disciplinary action
Any Member that has previously been required to adopt the enhanced supervisory requirements; has, in fact, fulfilled that requirement either by adopting the enhanced supervisory requirements for a prescribed period or by receiving a full or partial waiver from the enhanced supervisory requirements from the Waiver Committee; and subsequently becomes subject to a CFTC or NFA enforcement or disciplinary proceeding alleging deceptive sales practices, shall, within 30 days of being served with notice of the action, adopt all of the enhanced supervisory requirements and may not seek a waiver therefrom. This obligation shall continue until after the disciplinary or enforcement proceeding is closed and all appeals are completed or the time for appeal has passed without an appeal being filed or perfected.
- b. Members already subject to the enhanced supervisory requirements
IV. WAIVER PROCEDURE
Any Member required to adopt the enhanced supervisory requirements may seek a waiver by filing a petition with the Waiver Committee within 30 days of the date of being notified by NFA that it is required to adopt the enhanced supervisory requirements. NFA may grant such a waiver upon a satisfactory showing that the Member's current supervisory procedures provide effective supervision over its employees, including enabling the Member to identify potential problem areas before customer abuse occurs. Additionally, if a Member meets the criteria and trades security futures products, then the Member firm must also make a satisfactory showing that the Member's supervisory procedures ensure compliance with all applicable securities laws and regulations. Should a Member fail to file a petition seeking a waiver within 30 days or should it file a petition that is denied by the Waiver Committee, either in whole or in part, the Member may not petition for a full or partial waiver again until at least two years have elapsed since the Member adopted the required enhanced procedures. Members that meet the criteria to adopt the enhanced supervisory requirements and receive either a full or partial waiver of their obligation to adopt those requirements are, nevertheless, deemed to be a Member that qualified for the requirements for the purposes of this Interpretive Notice.
Some of the factors that the three-member Waiver Committee may consider in evaluating a waiver request include:
- the total number and the backgrounds of APs sponsored by the Member;
- number of branch offices and GIBs operated by the Member;
- the experience and background of the Member's supervisory personnel;
- the number of the Member's APs who had received training from firms which have been closed for fraud, the length of time those APs worked for those firms and the amount of time which has elapsed since those APs worked for the disciplined firms;
- the results of any previous NFA examinations;
- the cost effectiveness of the taping requirement in light of the firm's net worth, operating income and related expenses;
- whether the Member assesses commissions, mark-ups, fees and other charges that are based on all of the relevant circumstances, including the expense of executing orders and the value of services the Member renders based on its experience and knowledge; and
- whether the Member adequately discloses the amount of commissions, mark-ups, fees and other charges before transactions occur in light of a retail customer's trading experience and the impact that the commissions, mark-ups, fees and other charges may have on the likelihood of profit.
Conditions that the Waiver Committee shall impose on any Member to which it grants a full or partial waiver include requirements that the firm: notify NFA of any action charging the firm with a violation of CFTC, SEC or Self Regulatory Organization ("SRO") regulations or rules; notify NFA of any customer complaint involving sales practices or promotional material; not change ownership; not have any material deficiencies noted during any SRO examination; not hire additional APs from Disciplined Firms; execute a written acknowledgement that the firm understands the conditions of the waiver; and may include any other conditions deemed by the Committee to be appropriate in consideration of a total or partial waiver from the enhanced supervisory requirements. Violation of any of those conditions may serve as cause for the Waiver Committee to review and amend or revoke the waiver.
Any FCM, IB, CPO and CTA Member or FDM that does not comply with this Interpretive Notice will violate NFA Compliance Rule 2-9(b) or 2-36(e) and will be subject to disciplinary action.
1 The Board notes that NFA Registration Rule 214(a) requires sponsors to file a Form 8-T with NFA reporting the termination of an AP within 30 days of their termination. Members should be aware that, notwithstanding that Rule, a Member's obligation to adopt the enhanced supervisory requirements is conclusively established on any day on which its sales force meets one of the listed numerical criteria and that the obligation shall not be extinguished by the effect of the subsequent filing of a Form 8-T for a terminated AP even if the form is filed within 30 days of an AP's termination.