The National Futures Association (NFA) has submitted to the Commodity Futures Trading Commission (the CFTC) a proposed amendment (the “Proposal”) to NFA Compliance Rule 2-46. Unlike other proposed amendments that improve or enhance a technical aspect to an NFA rule, the Proposal breaks new ground for NFA.
The Proposal would require registered commodity pool operators (CPOs) and commodity trading advisors (CTAs) to report quarterly to NFA their net worth and profitability. CPOs and CTAs currently are required to report on the assets and pools that they manage – but this is the first time that CPOs and CTAs will have to report on their finances as operating businesses.
NFA currently receives reports on the financial condition of futures commission merchants (FCMs), which are futures brokerage firms that hold customer funds. Even though the CFTC prohibits CTAs from holding customer funds and requires all pool assets to be held in the pool’s name, not the CPO’s, NFA believes that it is necessary to collect quarterly financial information on CTAs and CPOs to determine “a firm’s risk profile and to identify firms that may be facing financial difficulties.”
The Proposal is similar in nature, though not as intrusive, as a concept release issued in January 2014 in NFA Notice 1-14-03. In that Notice, NFA asked for industry comments to setting minimum financial standards for CTAs and CPOs and requiring periodic reports of their financial condition to NFA. The industry reacted negatively—focusing on existing customer protections that insulate customers from losses due to the bankruptcy or insolvency of a CTA/CPO—and NFA did not move forward with its 2014 proposal.
Specifics of Proposal
NFA is seeking CFTC approval to amend NFA Rule 2-46 to require CTAs and CPOs to report on Form PQR on a quarterly basis the ratio between the Member’s (i) current assets and current liabilities, and (ii) total revenue and total expenses. The reports would be required to follow generally accepted accounting principles or other internationally recognized accounting standards, including the use of accrual-based accounting.
The Member firm must be able to demonstrate how it calculated the ratios. It must retain the underlying financial records that formed the basis for the calculations and reports and make those records available to NFA upon request or during an examination. For Member firms that are subsidiaries, the proposal allows such firms to report the ratios at the parent or holding company level.
It is important to point out that each of the CFTC and NFA has its own version of Form PQR. Existing NFA rules allow NFA to prescribe the “form and manner” of the information on its form. However, the CFTC creates their forms which are set forth in Appendix A to CFTC Rule 4.27. Under the Proposal, Member firms that are required to file the CFTC Form PQR (and thereby are deemed to satisfy NFA’s Form PQR) also must include “any additional information in a form and manner prescribed by NFA.” In this way, CPOs required to file CFTC Form PQR will be subject to the financial reporting in the Proposal.
The Proposal does not establish a minimum standard of net worth or profitability or indicate what NFA would do if a Member firm reported low or negative net worth or profitability.
Except for banks or brokerages, it is unusual for a regulator to impose this type of reporting burden on a regulated entity not in possession of customer funds. NFA indicated in its Notice 1-14-03 that 92 percent of its Member Responsibility Actions (MRAs) from 2011 to 2013 were against CPOs and CTAs, and most involved misuse of customer funds or misstating net asset values or past performance. NFA did not give any data as to how many of those MRAs involved low profitability CPOs or CTAs.
It is intriguing that NFA is focusing on profitability as a measure of regulatory risk. Certainly, a Member firm that is breaking even is just as able and capable to comply with NFA rules as another Member firm that is highly profitable. Further, the largest and most pervasive financial frauds in the last decade (Enron, Sentinel, Madoff and the LIBOR and FX manipulation scandals against J.P. Morgan Chase, UBS, Citibank, Royal Bank of Scotland) involved businesses with billions of dollars on their balance sheet. However, based on the language in Notice 1-14-03 and the Proposal, NFA likely would designate a Member firm with little or no profitability as high risk in terms of non-compliance and/or customer fraud.
Perhaps NFA believes that low profitability provided the motivation for MRAs that involved misuse of customer funds or misstating net asset values or past performance. On the other hand, due to the resource demands of start-up CTAs and CPOs, like any new business ventures, profitability may be impacted in the early stages of the business lifecycle. Thus, NFA’s Proposal will likely be most detrimental to these “small businesses” who are suffering low profitability for many various other legitimate business reasons.
While NFA points out that low profitability is not a rule violation, such a designation likely would lead to an NFA examination. The exam might include a request for (i) bank statements and other source documents to prove the accuracy of the quarterly report, (ii) brokerage and bank statements of all pools and managed accounts to confirm that the Member firm has not invaded those accounts, and (iii) how the Member firm intends to restore its financial condition. The Member firm might be put in the position of having to prove its innocence—that is has not stolen customer funds—which the Member firm has to prove solely because it has low profitability numbers. Such examinations also will impose additional legal and compliance costs on Members which may not be the best use of the Members’ already limited resources.
There also is an interesting question whether the Proposal is an “end around” the Administrative Procedures Act. The Proposal would alter the information required to be filed by CPOs that are obligated to file the CFTC’s Form PQR. However, the CFTC is not proposing to amend its rules; therefore, there is no public comment period and the CFTC does not have to do a regulatory analysis, including the effects on small businesses, which most CPOs and CTAs are.
Lastly, if the Proposal is adopted, the reports may be subject to Freedom of Information Act requests. Accordingly, CPOs and CTAs should request confidential treatment so that their proprietary financial information is not made public.
The NFA’s Proposal can be accessed here. If you have any questions or would like to discuss these issues in more detail, please contact David M. Matteson or the Drinker Biddle & Reath attorney with whom you regularly work.