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9006 - NFA COMPLIANCE RULE 2-13: GUIDELINE FOR THE DISCLOSURE BY CPOS AND CTAS OF "UP FRONT" FEES AND ORGANIZATIONAL AND OFFERING EXPENSES
(Board of Directors, effective July 1, 1986; revised November 26, 1996 and June 30, 2020.)
Commodity Futures Trading Commission ("CFTC") Regulation 4.24(i) states that the disclosure document of a CPO must contain a description of each expense which has been or is expected to be incurred by the pool. CFTC Regulation 4.34(i) applies to CTAs and requires that the disclosure document of a CTA describe each fee which the CTA will charge the client. In addition, CFTC Regulations 4.24(w) and 4.34(o), respectively, require CPOs and CTAs to disclose all "material" information. These requirements have been incorporated into NFA Compliance Rule 2-13. Because "up front" fees and charges can have a significant impact on the net opening equity of pools and managed accounts, the above NFA rule requires not only disclosure of the existence and the amount of the up front charges but also disclosure of how the up front charges affect the return which must be achieved to break even at the end of an investor's first year or the initial amount of capital available for trading. Furthermore, the impact of the up front charges on net performance must be included in the rate of return figures reflected on a CPO's or CTA's required past performance presentation.
A. Disclosure of Prospective Up Front Fees and Charges
The disclosure document must disclose up front fees and expenses, if any, to participants in a pool or clients in a managed account. NFA's Board of Directors believes that investors should be fully aware of not only the amount of such fees and expenses but also their impact on the return which must be achieved to break even at the end of the investor's first year or the net proceeds that will be available at the outset for futures trading. For a CPO, NFA Compliance Rule 2-13(b) provides that a CPO's disclosure document must include break-even analysis presented in the manner prescribed by NFA's Board of Directors, which is described in a separate interpretive notice. (See Interpretive Notice Compliance Rule 2-13: Break-Even Analysis.) CTAs may provide similar information either through the use of break-even analysis which complies with the requirements of Compliance Rule 2-13(b) and the accompanying interpretive notice or through the use of a dilution table.
If a CTA chooses to use a dilution table, the dilution table should be highlighted in a tabular format on the cover page of the disclosure document. The suggested format for the table would detail a standardized amount of initial investment, all up front fees and charges, including all sales and administrative fees, and the net proceeds that would be available for trading after deducting the up front expenses. If a CTA does not use standardized amounts, minimums or units for initial investments, the required table should be presented showing dilution of an investment of $1,000. Moreover, if the results in the dilution table, without further explanation, could be materially misleading as to the impact of the up front fees and charges on the amount of initial capital available for trading (for example, because the fees as a percentage of the initial investment vary depending on the amount of the investment), then explanatory footnotes should be used.
The extent to which a CTA breaks down the up front expenses into categories, including, but not limited to, fees, sales and administrative fees, is solely within the discretion of the CTA as long as the net proceeds for trading and the portion that is deducted from the initial investment are clearly delineated as such. All fees that are charged up front must be disclosed except that a CTA that charges periodic management fees on the first day of each period, including the initial period, need not describe such fees for the first period in the dilution table.
B. Treatment of Up Front Fees in the Required Past Performance Presentation
In preparing rate of return information, the beginning net asset value of a pool or managed account must be calculated before any up front fees and expenses, including organizational and offering expenses, are deducted. However, a CTA acting as an independent advisor to a commodity pool is not required to include the up front fees or expenses charged by the CPO in beginning net asset value for the purposes of calculating rate of return information for the CTA's own disclosure document. In general, a CTA is acting as an independent advisor if it is not an affiliate of the CPO and does not receive any portion of the up front fee. For these purposes, "affiliate" means any advisor which owns or controls, is owned or controlled by, or is under common ownership or control with the CPO.
All up front fees and organizational expenses must be reflected as a reduction of net performance in the period in which the contribution was made to the pool or client's managed account, unless such fees and expenses can be amortized pursuant to Generally Accepted Accounting Principles.1 If organization or syndication expenses can be, and are, amortized, then net performance shall be reduced each month by the monthly amortizable amount. The monthly amortizable amount shall be calculated by dividing the total amount of amortizable expenses by the total number of months over which such expenses shall be amortized.
1 Section 709 of the Internal Revenue Code, 26 U.S.C. §709, governs whether or not organization or syndication expenses incurred to organize and to promote the sale of interests in a partnership can be amortized