On January 23, 2014, the National Futures Association (NFA) issued a Request for Comments from commodity pool operators (CPOs) and commodity trading advisors (CTAs) as to whether the NFA should adopt rules to: (1) ensure that CPOs and CTAs have sufficient assets to operate; (2) strengthen the regulatory structure governing CPOs’ operations; and (3) afford greater protection to CPO customer funds.1 The deadline for submission of comments to the NFA is April 15, 2014. Comments may be sent via e-mail to CPOandCTAfeedback@nfa.futures.org.
Requirements Contemplated by the Request for Comments 2
Minimum Capital Requirements for CPOs and CTAs
Currently, CPOs and CTAs are not required to maintain a minimum amount of capital under CFTC regulations or NFA rules. This is in contrast to capital requirements applicable to other CFTC registrants, such as introducing brokers— which, unlike CPOs and CTAs, are prohibited from holding customer funds—and futures commission merchants. According to the NFA, CPOs and CTAs act as fiduciaries to their pool participants and clients, respectively, and therefore should be required to have adequate funds to operate. The Request for Comments poses numerous questions about whether and how the NFA should impose a capital requirement on CPOs and CTAs. The questions presented include: (1) whether there are alternatives to capital requirements available for ensuring that CPOs and CTAs have sufficient funds to operate as a going concern; (2) how “net capital” should be defined (e.g., current assets minus liabilities or alternative calculations); and (3) how to determine an appropriate amount of required capital. The NFA also seeks inputs on the frequency and nature of any accompanying financial reporting as well as whether CPOs and CTAs should be subject to distinct requirements.
CPO Customer Protection Methods
Customer protection, including the protection of customer funds, is a highly visible area for both the CFTC and the NFA. 3 According to the NFA, many of its recent, fraud-oriented investigations and matters involve commodity pools and the misuse of customer funds in some manner. Generally, the Request for Comments reflects the view that CPOs are not sufficiently regulated and should be subject to increased oversight, because they: (1) have been a source of fraud in the past; (2) hold customer money with minimal transparency into the day-to-day operation and use of the funds, as compared to futures commission merchants, for example; and (3) they are now one of the largest categories of CFTC registrants.
Among other things, the NFA is considering, and requesting comments with respect to, whether: (1) CPOs should be required to obtain authorization from an independent third party to disburse pool funds; (2) commodity pool statements, reports, and performance results should be prepared or verified by an independent third party; and (3) CPOs should be required to report pool assets to the NFA on a daily basis. 4
The NFA proposals described in the Request for Comments are far-reaching and could be onerous, particularly for CPOs with multiple sophisticated commodity pools. The requirement to use an independent third party for various functions could be quite costly and would likely present operational burdens related to the manner and timing within which reports and statements are prepared and fund disbursements are made. Verification of pool assets with the NFA on a daily basis also could be costly and burdensome for CPOs. The Request for Comments reflects some sensitivity to these issues in that it expressly asks whether the proposed requirements would have the desired effect of protecting customer funds and preventing misappropriation of those funds. The questions invite comments on the impact of the proposals on CPOs, and the hope is that the NFA will carefully weigh the benefits of the proposed requirements against the costs and burdens they would impose.
The NFA’s Request for Comments is not a formal rule proposal and, accordingly, the changes to the CPO and CTA regulatory regime contemplated therein are not imminent. Nevertheless, adoption of such changes would constitute a shift in focus for the NFA to more enforcement-oriented operations. To date, the enforcement operations of the NFA have been relatively small compared to the operations of the Division of Enforcement of the CFTC: they have mainly consisted of member responsibility actions for violations of the NFA’s rules.
Imposition of additional rules and regulations is often indicative of regulatory priorities and, therefore, can lead to more enforcement action in that area. From the Request for Comments it is clear that, if the contemplated capital requirements and customer protection measures are adopted, both the NFA and the CFTC would have more ammunition to bring cases for technical rule violations in the CPO and CTA space. Accordingly, CPOs and CTAs may wish to consider submitting detailed comments to the NFA in response to the Request for Comments. Doing so will ensure that the NFA takes into consideration all relevant facts prior to taking any actions. This is particularly important because many CPOs and CTAs are also registered with the Securities and Exchange Commission (SEC) as investment advisers. Existing SEC compliance and regulatory requirements applicable to investment advisers would conflict with those contemplated in the Request for Comments. How such requirements would be harmonized, if at all, and the operational costs and burdens of compliance, are likely to be significant. 5
1 The NFA is a self-regulatory organization to which the Commodity Futures Trading Commission (CFTC) has delegated intermediary registration and certain oversight functions.
2 In addition to the measures summarized below, the Request for Comments also solicits input with respect to the treatment of CPOs and CTAs that are inactive members of the NFA because they no longer engage in any commodity interest trading. Generally, the Request for Comments inquires as to whether such inactive members should be permitted to remain NFA members.
4 The Request for Comments notes that futures commission merchants are currently subject to a daily reporting requirement.
5 It should be noted that the CFTC adopted rules last year to harmonize the compliance obligations of investment advisers to registered investment companies with the CPO and CTA requirements. Please see Sutherland’s August 26, 2013, Legal Alert, “CFTC Finalizes Harmonization Rules: Advisers to RICs Benefit From ‘Substituted Compliance’ for Many Obligations,” for more information.