NSCP CURRENT S December 2013 - Dechert · 3 NSCP CURRENT S December 2013 SEC Charges an Investment Adviser to a Money Market Fund and One of its ... Protection Act of 2010,

NSCP CurreNtS December 2013


SEC Charges an Investment Adviser to a Money Market Fund and One of its Employees with Deceiving the Fund’s Board and Causing the Fund to Violate Rule 2a-7By Stephen T. CohenPage 3

Business Continuity Planning – Some Practical ConsiderationsBy Craig Watanabe, CSCPPage 6

Annual Broker-Dealer ReviewsBy Matthew C. DwyerPage 9

The “3 R’s”: Registration, Reporting and Recordkeeping for Investment Advisers, Private Funds and NFA Members: How The Dodd-Frank Act Forever Changed the Regulatory Landscape By Myles J. Edwards, Esq. & Teresa CooperPage 16

Life After CPO Registration: A Look at Several Significant CFTC and NFA Compliance Obligations that Lie Ahead for this Year’s Bumper Crop of Newly Registered CPOsBy Sean Finley, Nathan Greene, Jared Gianatasio, and Zachary BodmerPage 21

New MembersPage 30

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SEC Charges an Investment Adviser to a Money Market Fund and One of its Employees with Deceiving the Fund’s Board and Causing the Fund to Violate Rule 2a-7By Stephen T. Cohen

INTRODUCTION

On November 26, 2013, the U.S. Securities and Exchange Commission (“SEC”) instituted public administrative and cease-and-desist proceedings against Ambassador Capital Management, LLC (“ACM”) and one of its employees who served as the primary portfolio manager of the Ambassador Money Market Fund (“Fund”).1 The SEC alleges that ACM and the portfolio manager (i) deceived the Fund’s board of trustees (“Board”) and (ii) caused the Fund to violate Rule 2a-7 under the Investment Company Act of 1940, as amended (the “1940 Act”), the rule governing money market fund investments and operations.

Although the enforcement action did not include ACM’s or the Fund’s compliance personnel, the allegations raise a number of issues that should be considered by chief compliance officers (“CCOs”) and other compliance professionals. This article will (i) provide background on the enforcement action, including the role of the SEC’s Division of Investment Management (“Division”) in uncovering the alleged fraud through an analytical review of the Fund’s performance data; (ii) review the allegations made by the SEC; and (iii) discuss potential issues for CCOs and compliance professionals to consider in order to address the types of conduct alleged by the SEC.

This enforcement action has not been settled and is part of an ongoing investigation. Accordingly, the allegations described herein have not been adjudicated and are based solely on the Order and Press Release.

1 See In the Matter of Ambassador Capital Management, LLC, Investment Company Act Rel. No. 30809 (Nov. 26, 2013) (“Order”), available at www.sec.gov/litigation/admin/2013/ia-3725.pdf; see also SEC Announces Fraud Charges Against Detroit-Based Money Market Fund Manager, U.S. Securities and Exchange Commission (Nov. 26, 2013) (“Press Release”), available at www.sec.gov/News/PressRelease/Detail/PressRelease/1370540414950#.UqD54VtDvAk.

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Background on aCM, the Portfolio Manager and the Fund

ACM is a registered investment adviser with its principal place of business in Detroit, Michigan. ACM primarily invests in fixed-income securities on behalf of its clients. According to its most recent Form ADV, ACM has approximately $1.1 billion in assets under management.

The portfolio manager at ACM named in the Order was primarily responsible for managing the Fund from 2009 until the Fund’s liquidation in June 2012. The portfolio manager holds the position of Director of Quantitative Research at ACM. The portfolio manager is a chartered financial analyst and is responsible for managing the short- and long-term portfolios for ACM.

Prior to its liquidation, the Fund operated as a “prime” money market fund. The Fund was a series of Ambassador Funds, an open-end diversified management investment company registered with the SEC. The Fund was designed to appeal to Michigan municipalities and, from time to time, more than half of the shareholders’ investments in the Fund came from two municipalities, the City of Detroit and Washtenaw County, Michigan.

Background on the Division’s Risk and Examinations Office and Its Role in analyzing Performance Data

The Risk and Examinations Office is a new office within the Division. Created in 2012 to assist the SEC in complying with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the Risk and Examinations Office provides the Division “with the capability to perform quantitative risk analysis”2 and, among other things, manages, monitors and analyzes the industry data the Division receives.

2 See OCIE Compliance Outreach Program, The Division of Investment Management’s Risk and Examinations Office, Recent Developments (Sept. 13, 2013), available at http://www.sec.gov/info/cco/cco-2013-09-13-presentation-recent-developments.pdf.

Stephen T. Cohen is a Senior Associate in the Financial Services Group of Dechert LLP and primarily represents U.S. registered investment companies and investment advisers with respect to a wide variety of regulatory, compliance and securities law issues. This article is based in part on a DechertOnPoint authored by Jack W. Murphy, Stephen T. Cohen and Brenden P. Carroll.

http://www.sec.gov/litigation/admin/2013/ia-3725.pdf

http://www.sec.gov/litigation/admin/2013/ia-3725.pdf

http://www.sec.gov/info/cco/cco-2013-09-13-presentation-recent-developments.pdf

http://www.sec.gov/info/cco/cco-2013-09-13-presentation-recent-developments.pdf


According to the Press Release, the SEC credited the “ongoing quantitative and qualitative analysis of the asset management industry” conducted by the Division’s Risk and Examinations Office as playing a “vital role” in this enforcement action. In fact, the Press Release states that the enforcement action “stem[med] from an ongoing analysis of money market fund data by the SEC’s Division of Investment Management, in this case a review of gross yield of funds as a marker of risk.” Moreover, Norm Champ, the Division’s Director, stated in the Press Release that “this [enforcement action] is an excellent example of how [the SEC’s] investment in data analysis leads directly to investor protection.”

Based on the concerns raised by the Division’s Risk and Examinations Office, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) conducted an on-site examination and, following that examination, referred the matter to the Asset Management Unit of the SEC’s Division of Enforcement.

SEC’S allEgaTIONS agaINST aCM aND ThE PORTFOlIO MaNagER

Deceiving the Fund’s Board

The SEC alleges that ACM and the portfolio manager violated the federal securities laws by repeatedly and knowingly deceiving the Fund’s Board regarding: (i) the credit risk of the Fund’s portfolio securities; (ii) the extent to which the Fund was exposed to asset-backed commercial paper potentially affected by the 2011 European sovereign debt crisis; and (iii) the diversification of the Fund’s portfolio.3

Withholding the Credit Risk of the Fund’s Portfolio Securities

The SEC alleges that, between June 2009 and May 2012, ACM repeatedly withheld information from the Board regarding the credit risk of the Fund’s portfolio securities. Specifically, the SEC alleges that:

1. ACM regularly purchased securities for the Fund that exceeded ACM’s internal maturity restrictions, which had been imposed by ACM in an attempt to limit the Fund’s risk exposure to certain investments; and

2. ACM repeatedly purchased for the Fund portfolio securities without making the determination that the securities posed “minimal credit risk,”4 as required by Rule 2a-7 and ACM’s own Rule 2a-7 guidelines and procedures, by causing the Fund to purchase securities that ACM identified as presenting “risk,” “some risk,” “moderate risk” and “slightly moderate risk,” which the SEC claims had “significantly higher credit spreads and thus yield” than the securities for which ACM determined presented minimal credit risk.

3 The Fund’s Board was not named in the Order. 4 Under Rule 2a-7, a money market fund’s board or the board’s designee must determine that a security presents “minimal credit risk,” which is separate from the credit rating status of the security.

Misleading the Board about the Fund’s European holdings

The SEC claims that ACM and the portfolio manager made false and misleading statements to the Fund’s Board regarding the Fund’s exposure to European issuers during the European sovereign debt crisis in 2011. The SEC alleges that ACM and the portfolio manager continued to purchase and hold dollar-denominated asset-backed commercial paper affiliated with a financially-troubled European country, notwithstanding statements made to the Board during Board meetings that the Fund would have only limited or no exposure to that country. In fact, the Order states that, although ACM reported to the Board that the Fund would be reducing exposure to troubled European markets, including, in particular, the Italian market, ACM and the portfolio manager caused the Fund to purchase Italian-affiliated asset-backed securities on several occasions after that statement was made.

Misleading the Board Regarding Issuer Diversification

The SEC further alleges that ACM provided false and misleading information to the Fund’s Board regarding the Fund’s diversification of portfolio securities. Rule 2a-7 requires a money market fund to be diversified with respect to securities issuers by generally limiting the fund’s exposure to securities of any one issuer to no more than 5% of the fund’s total assets, at the time of purchase. Although compliance with this requirement is measured immediately following a purchase or acquisition of securities, ACM allegedly stated to the Board that the Fund would not have exposure to securities of an issuer in excess of 5% following a particular date. However, the SEC alleges that the Fund held securities of ten issuers on that date, exceeding the self-imposed 5% limitation.

As a result of the foregoing, the SEC alleges that ACM willfully violated, and the portfolio manager willfully aided and abetted and caused ACM’s violations of, Sections 206(1) and (2) of the Investment Advisers Act of 1940, the antifraud provisions under that Act.

Causing Violations of Rule 2a-7

The Order also alleges that ACM caused the Fund to violate certain requirements under Rule 2a-7, in addition to the failure to make required determinations that portfolio securities present minimal credit risks. These allegations include:

1. causing the Fund to purchase ten different securities on six separate dates that caused the Fund to exceed the issuer diversification limits of Rule 2a-7(c)(4)(i);

2. after the amendments to Rule 2a-7 in 2010, failing to implement written procedures providing for stress testing of the Fund’s ability to maintain a stable net asset value per share in light of several hypothetical scenarios, as required by Rule 2a-7(c)(10)(v)(A); and


3. failing on certain occasions to conduct stress testing that included hypothetical increases in redemptions of Fund shares5 and the impact of a downgrade of portfolio securities,6 as required by Rule 2a-7(c)(10)(v)(A).

As a result of the alleged violations of Rule 2a-7, the SEC alleges that the Fund was not entitled to rely on Rule 2a-7 to use the amortized cost valuation method to price its shares at $1.00 and should have calculated its net asset value per share under Rule 22c-1 under the 1940 Act. The SEC therefore alleges that ACM and the portfolio manager had caused the Fund to violate Rule 22c-1, as well as Sections 34(b)7 and 35(d)8 of the 1940 Act. The SEC also alleges that ACM had caused the Fund to fail to implement written compliance policies and procedures that were reasonably designed to prevent violations of the federal securities laws, including policies and procedures providing for oversight of compliance by the Fund’s investment adviser.9

POTENTIal ISSUES FOR CCOs aND COMPlIaNCE PROFESSIONalS

This enforcement action raises certain points for consideration by CCOs and other compliance professionals. Below are a few to consider:

Monitoring aberrational Fund Performance

The analytical tools of the Division’s Risk and Examinations Office have provided the SEC and its staff with the ability to better detect aberrational performance. This is particularly true with respect to money market funds, because such funds disclose on their websites and file with the SEC on Form N-MFP detailed data regarding their portfolio holdings. Although this enforcement action relates to a money market fund, the use of these analytical tools is not limited to money market funds.10 As a result of this new level of efficiency in analyzing fund 5 As support for the importance of stress testing for increased Fund redemptions, the Order noted that the City of Detroit, a financially-distressed municipality, was heavily invested in the Fund, and that the cash invested by the City fluctuated substantially. 6 The Order noted that, since the Fund regularly purchased and held securities with exposure to the European sovereign debt crisis, the risk of downgrades should have been a part of the Fund’s stress testing.7 Section 34(b) prohibits a person from making any untrue statements of material fact in reports, accounts, records or other documents filed with the SEC. 8 Section 35(d) prohibits a registered investment company from adopting a name that could be materially deceptive or misleading. 9 Among other things, the Order noted that the Fund had not amended its Rule 2a-7 procedures in the wake of the amendments to that rule in 2010. 10 See SEC Charges Multiple Hedge Fund Managers with Fraud in Inquiry Targeting Suspicious Investment Returns, U.S. Securities and Exchange Commission (Dec. 1, 2011), available at http://www.sec.gov/news/press/2011/2011-252.htm. (“Under the initiative — the Aberrational Performance Inquiry — the SEC Enforcement Division’s Asset Management Unit uses proprietary risk analytics to evaluate hedge fund returns. Performance that appears inconsistent with a fund’s investment strategy or other benchmarks forms a basis for further scrutiny.”)

performance data and aberrational performance and coordination with OCIE, CCOs and compliance professionals may wish to review their compliance processes to assure themselves that any fund performance that is materially higher than that of similar funds is reviewed to ensure that any outperformance is the result of the use of legitimate portfolio management techniques rather than investments that are prohibited under the 1940 Act, the fund’s (and the adviser’s) procedures, the investment parameters disclosed in the fund’s registration statement and any internal guidelines applied by the adviser when selecting investments for the fund.

Confirming Systems are adequately Updated

One of the allegations in the enforcement action is that certain securities violated the Fund’s investment strategies and Rule 2a-7. The Order identifies several alleged breaches to the diversification requirements under Rule 2a-7, as well as violations of ACM’s self-imposed restrictions on the Fund’s holdings. To address these concerns, CCOs and other compliance professionals should continue to ensure that systems have been properly “coded” to identify purchases that violate regulatory as well as internal investment restrictions.

Ensuring that Policies and Procedures are Updated to Reflect amendments to Rules and Regulations

The SEC alleges that the Fund’s policies and procedures had not been updated to incorporate the 2010 amendments to Rule 2a-7. For example, the SEC claims that the Fund did not fully implement stress testing procedures on a timely basis and that the stress testing that was implemented did not consider certain events required under Rule 2a-7. In light of these allegations, CCOs and other compliance professionals should continue to monitor regulatory developments and update compliance policies and procedures, as appropriate, to ensure that new or amended rules and regulations are incorporated accurately into the compliance program in a timely manner.

Conclusion

As of the date of the submission of this article, this enforcement action has not been settled and is part of an ongoing proceeding. Nevertheless, the allegations made by the SEC and the manner in which the investigation was initiated could serve as a blueprint for other enforcement actions. Therefore, CCOs and compliance professionals should consider reexamining their policies, procedures and practices to ensure that funds and other accounts are being operated in compliance with applicable law and any other internal investment guidelines and restrictions.

http://www.sec.gov/news/press/2011/2011-252.htm

http://www.sec.gov/news/press/2011/2011-252.htm


Theory versus Practice

Business continuity planning is easy to talk about, but challenging to implement. The SEC Office of Compliance Inspections and Examinations issued a risk alert on August 27, 2013 entitled, “SEC Examinations of Business Continuity Plans of Certain Advisers Following Operational Disruptions Caused by Weather-Related Events Last Year.”i This alert did a very good job of pointing out observed weaknesses and offered aspirational recommendations, but a reader would be left to their own devices to come up with practical and actionable ideas to improve their business continuity planning.

a Different Perspective on BCPs

In the September 2013 edition of NSCP Currents, Lorna Schnase wrote an excellent comprehensive article on “Business Continuity Planning for Advisers” which I highly recommend. You will find very little overlap in this article as we view BCPs from a different perspective.

The BCP lifecycle

The BCP Lifecycle begins with analysis and proceeds to solution design. However, many plans assume that you have to “play the hand you have been dealt.”

One key principle of business continuity planning is some systems are inherently more resilient than others

Having a resilient system greatly simplifies and improves business continuity planning.

Four Factors Contributing to Resilience

Resilient systems have:

1. Fewer elements subject to failure2. Greater reliability3. Portability4. Flexibility

Any system that rates highly in these four categories will be easier to backup.

laptop analogy

I realize that IT is often a challenging subject for compliance professionals, so the best way I can describe resilience is by using an example all of us can relate to — buying a new laptop computer. Let’s assume the laptop is the “system” and we need to implement a BCP. The laptop could be stolen, dysfunctional or simply replaced, and for the purposes of this example the reason is irrelevant.

The typical laptop will have an operating system, installed applications and user settings / data stored on the hard drive. We will consider three ways to transfer these elements to the new laptop.

The Manual Method

This is the most common. We buy a new laptop with the operating system installed. Then we have to load all of our applications from disks or download them from the internet. Finally, we transfer the data and redo all of the settings such as layout of the desktop, web favorites and preferences for each application. This is a tedious process but assuming the BCP contained adequate backups, it is a workable, albeit inefficient, solution. The new laptop will be able to replace the old laptop with no loss of functionality or data.

Business Continuity Planning – Some Practical ConsiderationsBy Craig Watanabe, CSCP

Craig R. Watanabe, CSCP is the Chief Compliance Officer of Penniall & Associates, Inc. in Pasadena, CA. After graduating from UCLA, Mr. Watanabe entered the securities industry in 1982. He has been a successful financial planner, Branch Manager, Operations Manager, Chief Compliance Officer and Chief Operating Officer. Since June 2008 his primary responsibility is to develop synergies within a robust wealth management group. He currently holds the Series 3, 4, 7, 24, 27, 53, 55, 63, 65 and 87 securities licenses, life & disability, variable contract, long-term care insurance licenses, licensed and bonded tax preparer, Certified Financial Planner (CFP), Accredited Investment Fiduciary (AIF), Certified Securities Compliance Professional (CSCP) and Notary Public. Mr. Watanabe is on the Wolters Kluwer Advisory Board as well as the NSCP Board of Directors. Mr. Watanabe is very active within the compliance community and brings a perspective from both the retail and management sides of the business.


The automated Method

A better way to setup the new laptop is to use PC migration software. These programs make this task easy; however, this might not be workable if the old laptop was stolen or dysfunctional. The programs are designed to transfer data from one computer to another and not restore from backups.

Virtualization

The previous two methods assume you “play the hand you have been dealt” and unfortunately, a laptop with an operating system, installed programs and data on the hard drive is not a resilient system. Instead one could setup a virtual machine where the operating system, applications and data are all accessed from the internet. The laptop is now essentially a terminal with an internet connection and replacing it involves very little effort. This system has fewer elements subject to failure, greater reliability, portability and flexibility. So, instead of starting with a BCP template and figuring out how you would replace an old computer, consider the old computer itself and how to improve the resilience of the system.

Paradigm Shifts

The two great trends that are dramatically changing technology are mobilization and virtualization. We will not address the trend toward mobile computing; however, virtualization is where technology is headed for many reasons, in addition to business continuity planning. Some of the other advantages are server consolidation, reduced power consumption, superior testing and development environments, dynamic load balancing, improved system reliability and greater security. A detailed discussion of the pros and cons is beyond the scope of this article, but virtualization is a trend we should all be familiar with.

a Minimalist Philosophy

One could have experienced an “aha moment” when we discussed virtualization of the laptop being a more resilient system but this could have quickly faded with a hard dose of reality. Not many of us are going to be able to convince senior management to virtualize our systems to improve disaster recovery capabilities.

Virtualization is not all-or-nothing and hybrid systems are common. In fact, many of the applications you already use are internet delivered or what is called software as a service (SaaS). Most clearing firm or custodial interfaces are SaaS. Instead of installing Microsoft Office on a computer, one could subscribe to Microsoft Office 365iii, which has identical functionality and is the first billion dollar SaaS enterprise. Going back to our laptop example, a computer that used MS Office 365 and stored all data in the cloud would be more resilient than an analogous system with MS Office and data stored on the hard drive.

We may not be able to virtualize our entire system right away, however, one thing we can do is adopt a minimalist philosophy to guide us in that direction. A minimalist philosophy is one where we strive to have as little hardware and software onsite as possible. This is done by taking advantage of SaaS and outsourcing until a complete virtual machine operating environment can be achieved. The utility of having a minimalist philosophy is it provides a framework for future decision-making. For example, if you currently have your email server onsite and are looking to replace or upgrade the hardware or software, the minimalist philosophy would guide you to outsourced solutions. Each time a component of your system is being evaluated you should be creating a more resilient system. Ironically, this improves your capability to respond to a significant business disruption but most BCPs do not drill down to the level of detail where these changes would be noted in the plan.

Disadvantages of Virtualization

There is no perfect solution. Virtualization is very robust in protecting against natural disasters including earthquakes, hurricanes, tornados, fires and floods but would be highly susceptible to disruptions of the internet, which is a significant risk. There are also considerations with regard to specific vendor’s reliability and security. However, for most small firms, a large and reputable vendor will have superior reliability and security compared to what can be achieved onsite with resident applications and data. On balance the advantages outweigh the disadvantages which is why we are seeing the paradigm shift toward virtualization.

According to the Gartner Group, a well-respected IT research firm, 43% of businesses fail immediately upon losing their computer data and an additional 50% fail in the next two years, leaving only a 7% survival rate.

Glossary

Cloud Computing - Cloud computing is an expression used to describe a variety of computing concepts that involve a large number of computers connected through a real-time communication network such as the internet.

SaaS - An abbreviation for software as a service and is also known as “on-demand software” supplied by Application Service Providers (ASPs). SaaS is a software delivery model in which software and associated data are centrally hosted in the cloud.

Virtualization - Is the act of creating a virtual (rather than an actual) version of a hardware or software platform.

Virtual Machine - A virtual machine (VM) is a software implementation of a computer that executes programs like a physical computer.


Your #1 Priority in BCPs

One element of BCPs stands above all others in importance, and that is protecting your data.

People, hardware and software can all to some extent be replaced, however, a business cannot afford to lose its data. There are some excellent cloud-based data backup services which are robust and completely automated; however, the key with data backup is redundancy. Make sure you have multiple backups with different sources that are able to protect against diverse threats. Scenarios-based testing can be helpful and here are a few examples.

“going Postal”

Can you protect your firm if someone with access at your firm is intent on maliciously destroying the data? I know of two firms that did not survive when the IT person deleted all of their data. Granted this is an extreme threat, but it can be mitigated by having an independent backup.

“No one person should have all of the keys to the kingdom”

At my firm, our IT person uses a cloud-based service to back up the data, but I use a different service, and neither of us has access to the other’s backups.

Electro-Magnetic Pulse (EMP) from a Solar Flare

Many of you are probably thinking I watch “Doomsday Preppers”iii on the National Geographic Channel, and I do. One

common scenario is preparing for an EMP caused by a solar flare. In 1859, the earth was hit by a solar flare that melted telegraph lines in Europe and North America. Lest you think this is a remote possibility, consider the fact that on July 31, 2013 the earth had a near miss from a solar flare that could have wiped out electronics in the United Statesiv. While this is extreme and we would all have much bigger problems than data loss if this were to happen, it highlights the advantages of combining optical storage (CDs and DVDs) along with magnetic storage. In addition to the cloud-based backups I periodically burn critical data on DVDs which would be impervious to an EMP or other electrical disturbance such as a lightning strike or power surge. In addition, if the internet were to go down, the DVDs serve as an excellent alternative backup of your critical data. Diversified backup strategies have utility in a broad spectrum of scenarios.

Conclusion

Your BCP will be much more robust if you have a resilient system. Virtualization is one of the prime paths to creating a robust system, and by adopting a minimalist philosophy, one can migrate toward a virtual environment over time. Finally, understand your priorities and protect your data through multiple diversified backup systems. Hoping for the best but planning for the worst could one day save your firm.

Endnotesi http://www.sec.gov/about/offices/ocie/business-continuity-plans-risk-alert.pdfii http://office.microsoft.com/en-us/iii http://channel.nationalgeographic.com/channel/doomsday-preppers/iv http://washingtonexaminer.com/massive-solar-flare-narrowly-misses-earth-emp-disaster-barely-avoided/article/2533727

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By now, your Supervisory Control Reviews and CEO Certification Reports are a distant memory from the first quarter. You probably used a considerable amount of time and resources to complete the review. If you have an upcoming regulatory exam or want to make sure you efficiently utilized your resources, you might have some questions about your review. “Did I cover all required areas?” “Did I review a large enough sample?” “What do other broker-dealers do that we do not?”

This article discusses the process of these reviews and provides helpful advice and suggestions for planning and executing your reviews.

First, we need to define each review and differentiate between the Supervisory Controls Review and the CEO Certification Report. The Supervisory Controls Procedures (SCP) Report must be completed by April 1, pursuant to NASD Rule 3012. The SCP Report details the firm’s system of supervisory controls, the summary of the test results and any written supervisory procedure (WSP) amendments created in response to the results. In essence, the SCP Report documents the firm’s supervisory system and changes to the system during the preceding 12 months. Pursuant to FINRA Rule 3130, the CEO Certification Report must detail the processes your firm has in place to establish, review, maintain, test and modify WSPs which are reasonably designed to achieve compliance with applicable rules and regulations.1

There’s an important difference between the two reviews. FINRA recommends that you use the reports together to address supervisory weaknesses. For example, if a firm’s Rule 3012 report consistently notes a firm’s failure to adopt WSPs around new regulatory requirements, the firm should consider whether its Rule 3130 processes adequately take into account new regulatory requirements.2 For this reason, most firms conduct the SCP Review and the CEO Certification Report in tandem. When properly completed and used together, the reports give a broker-dealer an excellent picture of its supervisory system. Also, the NASD Rule 3012 report and FINRA Rule 3130 CEO Certification Report can be combined as long as it is clear that the requirements for both rules are met.3

Like many big projects, it is tempting to begin immediately. As an experienced compliance professional, you may already know of areas where improvement is needed. Resist that urge and spend some time to carefully prepare a plan for your reviews.

Planning

To plan an efficient, effective set of annual reviews, there are number of questions a firm should ask. Some of the questions that should be addressed are listed below:

Q: Does the firm have any new business activities or products?

A: If so, you will obviously need to spend some time reviewing the new area. However, even if there are no new products, think about what procedures you have in place for incorporating new products. Are these procedures adequate?

Q: What were the results of regulatory exam(s) during the past year?

A: Incorporate regulatory exam findings into your SCP and CEO Certification reviews. If you were cited for a lack of WSPs or a failure to follow your WSPs, you most likely have already corrected these deficiencies. However, make sure to give your firm credit for the corrections in your internal reviews. Also, strongly consider re-testing any areas where your firm was cited for a failure to follow WSPs.

Q: What recent changes/developments have affected the industry?

A: Over the last several years, regulators have increased their focus on firm interactions with senior investors. Although your firm might not have many senior investors, you will want to focus some resources on them if your firm has a base of retail customers. You could accomplish this by reviewing variable annuity transactions (or complex investments) of clients older than a certain age. This not only enables your review to cover senior investors, but also variable annuities (or complex products) which are also an area of increased regulatory scrutiny.4

Q: What new rules have been implemented in the past 12 months?

A: Any new rules that affect your firm need to be incorporated into both reviews. The most recent rule changes that come to mind are the changes to the suitability rule. In 2012, how did your firm address the suitability rule changes? Was a review of WSPs surrounding these new rules incorporated into your SCP and CEO Certification reviews? For instance, did you alter branch office procedures to include documentation for “hold” recommendations? Did your branch office audits include a review of this new documentation requirement?

Q: What were the results of the firm’s internal branch office inspections?

A: There are a couple of issues to cover in regards to branch inspections. For instance, were there any material findings uncovered in any of the branch office inspections? If so, how did the firm react to these findings? Additionally, as suggested by a 2011 National Examination Risk Alert,5 were any of your branch office inspections unannounced? If not, what was the reason? Is this reason documented?

Annual Broker-Dealer ReviewsBy Matthew C. Dwyer

Matthew C. Dwyer owns MCD Consulting, a firm that specializes in providing compliance solutions and services to broker-dealers, investment advisers and hedge funds. He also assists firms prior to and during regulatory examinations and investigations.


Q: What were the results of last year’s SCP Report (3012) and CEO Certification Report (3130)?

A: You should re-visit last year’s reviews to determine what areas were covered and how weaknesses were corrected. If there are areas reviewed in either report that do not appear to pose a high risk to the firm, you may consider devoting fewer resources to this area(s) so that you can focus on more pressing areas.

Q: Were recommendations from last year’s reviews properly implemented?

A: If you updated WSPs (or implemented other recommendations) last year, you should test these areas to ensure that supervisors and associated persons are properly following these updated processes and procedures.

Q: What were the results of the firm’s Independent aMl Review and, if applicable, the Direct Market access Review (SEC Rule 15c3-5)?

A: Take the same approach that you took when reviewing regulatory exam findings. If WSPs were updated, test these procedures to ensure they work properly and that they are being followed. If there were other findings, make sure to test these areas as well.

Q: Does your firm have any producing managers, as defined by Rule 3012?6 Specifically, are there any producing managers who account for more than 20% of the business unit’s revenue during the preceding 12 months?

A: If so, your firm should have WSPs in place so that the producing manager is supervised by someone who is either senior to or otherwise independent of the producing manager. You should include a producing manager’s activity in the SCP review. Also, be sure to review the process for calculating the 20% threshold to make sure that the firm has included all producing managers subject to the rule.

Q: Was your firm required to apply for a limited Size Exception in regards to the SCP Report?

A: Your firm must notify FINRA if you have elected to use the Limited Size Exception. This exception is necessary if you are so limited in size and resources that there is no qualified person senior to or otherwise independent of the producing managers to conduct the necessary reviews.7 Additionally, you must notify FINRA 30 days prior to the date that the member first relies on the exception and document the factors used to determine the need for the exception.8

Although there is no requirement to put together an audit plan or an outline of either review, doing so will help you organize your review and decide how to allocate your resources (time, labor, etc.). Additionally, Generally Accepted Auditing Standards (GAAS) focus on three areas: Planning, Fieldwork, Reporting.9 There are no requirements for your reviews to conform to GAAS standards. However, as you will see, GAAS serves as an excellent guidepost in a number of situations related to your annual review. Use the information you gathered by answering the questions

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listed above to create an outline of your review. Some of the areas you will need to cover are listed below.

• Registration

• Training & Education

• Financial & Operational Procedures

• anti-Money laundering

• Supervisory Systems

• Custody of Customer assets

• Communications

• Insider Trading

• Employee Policies

Think about the other areas that your reviews will cover. Your firm should focus on all the applicable business areas. However, your outline is a chance to decide the amount of resources you will devote to each area. For instance, you may want to devote considerable resources to Trading if there were trade reporting or OATS issues during your last regulatory exam. Even if there were no trading and trade reporting findings during your last exam, it might be prudent to devote resources to this issue because it is a potential exam finding that often leads to formal action.

Once you have decided on the areas you will focus on, you will need to decide how you will cover these areas. What transactions or items will you test? How will you test each area? Will you review all items in a particular area or just a sample? If you will test a sample, how will you choose your sample? Finally, how will you report and present your results?

Many firms create a risk assessment to determine the covered areas and the amount of time they will devote to each resource. Two factors determine where an activity ranks in a basic risk assessment: the effect of an event occurring and the probability of it occurring.10 Accurately estimating the probability of an event occurring will help with properly ranking an event in the assessment. For instance, assume that the firm estimates that the probability of a power outage occurring that will necessitate

implementation of the Business Continuity Plan (BCP) during the next 12 months is 25% (if this event occurred last year, the probability might be higher). Next, what is the effect of this event on the firm? Assuming the firm has an adequate BCP, the effect might be negligible. However, any event that causes a firm’s BCP to be implemented may be reviewed during the firm’s next regulatory exam. Consequently, the effect might fall in the middle of an effect scale that ranges from immaterial to critical.11 Repeating these steps for all of the areas we intend to cover during the review allows us to properly rank the importance of each area of the review. Once these areas are ranked, you can devote a proper amount of resources to the area.

WSP gap analysis

The next step in the annual review is to complete a WSP Gap Analysis, which is required for the Rule 3012 Supervisory Control Review. However, the Gap Analysis also gives you valuable insight into how the firm’s WSPs are reviewed, updated and modified. This information is necessary to complete the FINRA Rule 3130 CEO Certification requirement. Also, as mentioned earlier, remember that your firm’s NASD Rule 3012 report and FINRA Rule 3130 CEO Certification Report can be combined as long as it is clear that the requirements for both rules are met.12

FINRA has a lengthy WSP checklist to use while completing your Gap Analysis. If a checklist is too time consuming, consider using other resources. For instance, if you have been subjected to a regulatory exam during the review period, were there any findings related to your WSPs? If so, use this as part of your Gap Analysis, assuming you have updated the procedures. Use other reviews (AML, Direct Market Access, etc.) which include a partial review of WSPs as a portion of your Gap Analysis. Additionally, you should have procedures in place to periodically update WSPs. If you don’t, a quarterly review of any new products, industry trends, regulatory notices, etc. is an excellent way to keep your WSPs current and reduce the Gap Analysis work that has to be completed annually.

After you have completed the Gap Analysis, you are ready to begin testing. Some of the questions you will need to address are “What will I test in each section?”, “How will I conduct this testing?” and “Will I test a sample or the entire population?”


Sampling

To answer these questions, we can use an example. Assume that you will be testing Retail New Accounts. You determine that your firm opened 500 accounts during the review period. Depending on your resources, you may prefer to select a sample instead of testing all 500 new accounts. How big a sample you choose depends on several factors. If your firm had deficiencies in your last regulatory exam regarding new accounts or it was flagged in last year’s review, you may consider taking a bigger sample than if there are no deficiencies in this area. Also, how much revenue does your firm produce from Retail New Accounts? If it is a large percentage, consider increasing the sample size. Finally, what is the business structure regarding this area? Are there remote branch locations with little in-person supervision? Does your firm employ registered representatives as independent contractors? If the answer to any of these questions is “yes,” consider increasing the sample size.

You have probably noticed that I still have not mentioned any specific numbers or percentages. It is difficult to find guidance regarding sample sizes. It may be helpful at these times to use GAAS as a guide. Although GAAS does not give numbers or percentages either, it sets the following criteria:13

• Set a tolerable error rate – Decide on a threshold of errors you are willing to accept. For instance, you might select 3% as a tolerable error rate for Retail New Accounts. This means that if less than 3% of the new accounts you review has errors, you will not expand your sample. However, according to GAAS, if you find evidence of fraud (forgery, high usage of P.O. boxes by a registered representative(s)), you should expand your review to include more activity from the branch or broker in question

and notify management. We are not bound by GAAS; we are just using the standards as a guide. However, in this case, it makes sense to open an investigation specific to the branch of representatives in question and inform senior management.

• Project your results to the population – If you reviewed 50 accounts and found 1 exception (without evidence of fraud), your review gains credibility if you describe the sample (50 accounts), the population (500 accounts), the exceptions (1 account), the error rate (2%) and the tolerable error rate (3%). As part of your review, you would state that no further review is necessary because the error rate was less than the tolerable error rate, which was determined prior to testing. This is important because it lets your audience (regulators and management) know that you are not shaping your recommendations to fit your agenda.

• Expand the sample if necessary – If the error rate exceeds the tolerable error rate it often makes sense to expand the sample. However, if you can explain the reason for the higher tolerable error rate, it may not be necessary to expand the sample. Additionally, if you have found enough evidence in the original sample to change the process or alter internal controls, it is not necessary to expand the sample. For example, if you found four new account forms that were not signed by the customer, it might not make sense to expand the sample if the four deficient accounts came from the same branch. You can already come to the conclusion that the process is out of control at this branch and begin taking corrective action. If you decide to expand the sample, your expansion should be focused on accounts opened at the branch in question. Finally, be careful that you leave yourself enough time and resources to expand samples if necessary.

Let us consider our 500 Retail New Account population again. Assume that you have determined you have enough time and resources to sample between 25-100 accounts (5%-20% of the population). If we have assumed a tolerable error rate of 3%, it may not make sense to sample 25 accounts (5%) because any deficiency at all will lead to a 4% error rate and we will be faced with the possibility of our expanding our sample. So, assume that there have been no regulatory exam findings regarding new accounts, but it makes up a significant amount of the firm’s revenue. In this case, a sample of 50 customer accounts (10%) might be a prudent sample size. The sample would be an appropriate size (both count and percentage). Hopefully, the testing of this sample leaves you with enough resources to expand the sample if it becomes necessary.

When selecting samples, there are a number of resources that can help you ensure a random sample. Microsoft Excel® has a random number generator within its Data Analysis function. Additionally, many web sites offer random number generators. Once the random numbers have been generated, simply pull the corresponding account. If you can easily number your population, these random number generators are extremely useful. Assuming your firm has a list of new accounts opened in an Excel spreadsheet (if not, there are numerous ways to easily export this information to Excel), run a random number generation function on the list of account numbers. The example below shows a population of ten accounts (left column), the Excel® random number generators and the four accounts selected (right column) by the random number generator.


If there is no way to number your population, consider using systematic sampling where you would select every 10th or 20th, etc. Be careful to avoid bias. Make sure to include the entire population when selecting a systematic sample. Regulatory scrutiny could increase if you inadvertently omit a branch or a portion of the alphabet.

Consider how to select a sample from a population that is much larger than our example. If Equity Orders are the subject of review, your population is likely significantly larger. In many cases, 5%-20% of this population could still result in a sample of thousands of transactions. We can reduce the sample size by reducing the population from which we will obtain the sample. Instead of using all 12 months of equity orders as the population, you can limit your population to one quarter or month. From there, selecting a representative sample using the process described above is much easier. You can also consider using the trading data of certain days instead of orders. However, be careful about eliminating too much of your population. If your sample will only come from one month, you should make sure that any exception reports related to equity orders are reviewed for a larger time period.

Although your sampling methodology may change from year to year, including a section regarding sampling in your Supervisory

Control Procedures is prudent. However, when crafting these SCPs, make sure to leave yourself enough flexibility to alter sampling when warranted.

Testing

Once testing begins, deficiencies are often easy to recognize. Using the Retail New Accounts example, an incomplete new account form would obviously be a deficiency. However, there are other deficiencies that might not be apparent. Do the dates of the registered representative’s and the principal’s signatures match? If not, did trading occur prior to supervisory approval? That would also be a deficiency. If time permits, create a checklist for each item of review. The new account control checklist would include the following questions/issues:

• Is customer information completed?

• Do investment objectives coincide with financial information and risk tolerances?

• Is the correct form used (most new account forms were updated in 2012 to reflect the new suitability rules)?

• Are all required signatures present?


• Are signature dates the same? Again, not necessarily a deficiency, but it is a potential red flag.

• Is AML and CIP information gathered (documentary and non-documentary evidence)?

If you find any deficiencies, investigate to determine the reason for the error. If the deficiency was due to human error, was the associated person responsible adequately trained? If human error is not the reason, do your firm’s internal controls and/or WSPs need to be modified? Updates to your WSPs are part of your 3012 Review as well as your 3130 CEO Certification Review. As mentioned earlier, the 3012 and 3130 reports can be combined. Consequently, there is no need to discuss WSP updates in two sections of your report. However, highlight any WSP updates in your report so that your audience can easily locate these sections.

A review of orders would obviously be different. You will want to review order tickets to ensure they have all of the information required per SEC Rule 17a-3. You can also use this sample to review other areas of your 3012 Review. For example, you can use this sample to review for Best Execution and Regulation NMS. If there are enough short sales in your sample, you can also use this sample to review for compliance with Regulation SHO. To conduct a review of Regulation SHO, simply follow the path of a short sale. If the stock is on your firm’s (or your clearing firm’s) Easy to Borrow List, there is not much need to investigate further. However, review a few short sales of stocks not on the Easy to Borrow List. Fail to Deliver reports are the easiest way to track these transactions. Does the process used to locate stock match your firm’s procedures? Is this process documented? If the answer to either of these questions is “no,” interview operations personnel to determine why inconsistencies exist.

For every area of review, once you have completed testing the sample, review your results to determine if the error rate exceeds the tolerable error rate. If the error rate does exceed the tolerable error rate, determine your next steps. If the cause of the

deficiencies is uncovered, it may not be necessary to expand your sample. If the extent of the problem has not yet been determined, expanding your sample size is most likely appropriate. Remember that if there is evidence of fraud (forgery, misappropriation of assets, violation of firm or industry conduct rule, etc.), this is a material event. Expand your investigation at the source of violation (the broker or branch level). Also, notify management once you are confident that your findings are accurate.

Reporting

If your firm has effectively carried out and documented the planning, risk assessment, sampling and testing portions of your annual reviews, the reporting of your annual reviews is relatively simple. Use the documentation you have created for each area to create your report. For instance, for New Retail Accounts, you should have documented why you will review the area (a significant source of revenue), the population subject to review (500 new accounts opened during the review period), the sample you will review (50 new accounts – 10% of the population), which accounts make up the sample (use of a random number generator or evidence of a systematic selection of a sample), how you reviewed the sample (the checklist of items to review on each New Account Form) and a discussion of any deficiencies. Remember, this discussion will include the tolerable error rate, the error rate and evidence of any additional action, including expansion of the sample. Finally, you will have already documented the need for improving internal controls and WSPs.

Include an executive summary for the 3012 SCP Review. This executive summary should include a brief description of your firm, names and titles of all individuals contributing to the report, a list of areas covered during the review and a brief discussion of any material findings. For the 3130 CEO Certification Review, you should also include an executive summary. Also, you will want to include the CEO Certification language and signature page. The required language for this page is listed on page 9:

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ANNUAL COMPLIANCE CEO CERTIFICATION

The undersigned is an executive officer of ___________________ (the “Member”). As required by SRO rules to which the Member is subject, the undersigned makes the following certification:

1. The Member has in place processes to:

a. Establish, maintain and review policies and procedures reasonably designed to achieve compliance with applicable FINRA rules and federal securities laws and regulations;

b. Modify such policies and procedures as business, regulatory and legislative changes and events dictate; and

c. Test the effectiveness of such policies and procedures on a periodic basis, the timing and extent of which is reasonably designed to ensure continuing compliance with FINRA rules and federal securities laws and regulations.

The undersigned has conducted one or more meetings with the Chief Compliance Officer since the firm was granted FINRA membership, the subject of which satisfies the obligations set forth in IM-3013.

The Firm’s processes, with respect to paragraph 1 above, are evidenced in a report reviewed by the executive officer, chief compliance officer and such other officers as the Firm may deem necessary to make this certification. The final report has been submitted to the Firm’s board of directors and audit committee (or equivalent bodies) at the earlier of their next scheduled meetings or within 45 days of the date of execution of this certification.

The undersigned has consulted with the Chief Compliance Officer and other officers as applicable (referenced in paragraph 3 above) and such other employees, outside consultants, lawyers and accountants, to the extent deemed appropriate, in order to attest to the statements made in this certification.

Dated this________________day of________________, 20xx

Signature________________________________________________

Printed Name________________________________________________

Obviously, you should conduct the meetings mentioned in the certification language above. During these meetings, it is important, for a number of reasons, for you to describe your annual reviews and the processes you used to complete these reviews. First and foremost, an engaged CEO, Audit Committee and Board of Directors are a powerful and necessary tool for creating a culture of compliance. Second, a compliance department is seen by some as a cost center. This is an opportunity to show the work your department has conducted as well as the value that the compliance department adds to the firm by documenting the processes that keep the firm compliant and avoid FINRA and SEC enforcement costs.

Conclusion.

The concepts and tools discussed in this article will give your annual reviews greater efficiency, effectiveness and credibility. Proper planning allows you to use available information to set the goals and requirements instead of using intuition or hunches. The WSP Gap Analysis and risk assessment give an initial picture of where the firm’s weaknesses and deficiencies may exist. Proper sampling and testing determine whether the firm has met expected thresholds. If thresholds have not been met, documentation and discussion of further investigation are necessary. Finally, proper reporting documents compliance with applicable rules and generates effective communication with management. Keep these resources and tools in mind when you conduct your next annual broker-dealer reviews.

This article was written by Matthew C. Dwyer and is reprinted with permission from Practical Compliance and Risk Management for the Securities Industry, a professional journal published by Wolters Kluwer Financial Services. The article may not be re-published without permission from Wolters Kluwer Financial Services. Originally published May/June 2013 Wolters Kluwer. ©2013 Wolters Kluwer.

(Endnotes)1 http://www.finra.org/Industry/Issues/SupervisoryControl/P038004 2 http://www.finra.org/Industry/Issues/SupervisoryControl/P037999 3 FINRA Supervisory Control FAQs http://www.finra.org/Industry/Issues/SupervisoryControl/P037999 4 http://www.finra.org/web/groups/industry/@ip/@reg/@guide/documents/industry/p197649.pdf 5 Issued by OCIE on 11/30/11- http://www.sec.gov/about/offices/ocie/riskalert-bdbranchinspections.pdf 6 http://www.finra.org/Industry/Issues/SupervisoryControl/P037999 7 NASD Rule 3012(a)(2)(A)(ii) 8 NASD Rule 3012(a)(2)(A)(iii) & NASD Rule 3012(a)(2)(A)(iv)9 Auditing & Assurance Services, 14e ISBN No. 0132575957- Pg 36-3710 Dwyer, M.C., Downing, J. Conducting Broker-Dealer Compliance Testing and Risk Assessments. National Society of Compliance Professionals. April 2011. 11 Dwyer, M.C., Downing, J. Conducting Broker-Dealer Compliance Testing and Risk Assessments. National Society of Compliance Professionals. April 2011. 12 FINRA Supervisory Control FAQs http://www.finra.org/Industry/Issues/SupervisoryControl/P037999 13 Auditing & Assurance Service, 14e ISBN No. 0132575957- Pg 486

http://www.finra.org/Industry/Issues/SupervisoryControl/P038004






http://www.finra.org/web/groups/industry/@ip/@reg/@guide/documents/industry/p197649.pdf

http://www.finra.org/web/groups/industry/@ip/@reg/@guide/documents/industry/p197649.pdf

http://www.sec.gov/about/offices/ocie/riskalert-bdbranchinspections.pdf

http://www.sec.gov/about/offices/ocie/riskalert-bdbranchinspections.pdf






The “3 R’s”: Registration, Reporting and Recordkeeping for Investment Advisers, Private Funds and NFA Members:How The Dodd-Frank Act Forever Changed the Regulatory Landscape By Myles J. Edwards, Esq. & Teresa Cooper

Introduction

The Dodd Frank Act (“DFA”)1

It has long been recognized that the foundation of American education is predicated upon the 3 “Rs”; reading, writing and arithmetic.2 As such, many of us in the halcyon days of our youth looked upon this precept as a method toward gaining understanding and knowledge which would ultimately further our education. Even today, when complexity has become ubiquitous especially as it relates to compliance and regulation, our contention is that reverting to the basics can ultimately result in creating effective and nimble compliance programs that are adroitly positioned to accommodate new initiatives such as the Dodd-Frank Act. This article will explore how the regulatory 3 Rs, Registration, Reporting and Recordkeeping will assist in complying with the requirements found under the Dodd-Frank Act.

A renewed call for increased transparency and accountability for participants in the financial services industry and the goal of strengthening enforcement through statutory means employing a risk-based approach led to the enactment of the DFA.3 Many trace the desire to enact comprehensive legislative to the repeal of the Glass-Steagall Act4 which some have argued led to the ensuing financial crisis5. The Glass-Steagall Act was the law of the land for financial services firms until November 12, 1999 when President Bill Clinton signed into law the Gramm-Leach Bliley Act, which, among other things, repealed it. One of the effects of the repeal was that it allowed commercial and investment banks to consolidate, a result highly criticized on a bi-partisan basis.6

The DFA has implemented far-reaching rules and regulations that affect domestic financial services firms. A synopsis of these requirements will be explored here.

Investment advisers & Private Funds

1st “R” Registration

The DFA eliminated the “private investment adviser” exemption contained in Section 203(b)(3) of the Investment Advisers Act and the intrastate registration exemption for investment advisers with any private fund client. This created a broader category of firms that are eligible to be registered with the United States Securities and Exchange Commission (“SEC”) as an Investment Adviser.

The primary litmus test for investment adviser registration is based on Regulatory Assets Under Management (“RAUM”),7 and generally firms with $100 million or more in RAUM are required to be registered with the SEC. Firms between $25 million and $100 million in RAUM are required to be registered with the respective state(s) where they conduct business and would be eligible for SEC registration only if (1) they would not be subject to registration and examination by their home states or (2) would otherwise be required to register with 15 or more states. Firms that act solely as an Adviser to Private (Hedge and Private Equity) Funds8 and have RAUM less than $150 million are exempt from registration but are still subject to recordkeeping and reporting requirements as determined by the SEC. Other firms, such as those who advise Venture Capital Funds, Small Business Investment Companies and Family Offices, may be exempt from registration. It is advisable for those firms seeking to enjoy the Family Office exemption to review carefully these requirements9 for exemption from registration, as they may be strictly interpreted.

2nd “R” Reporting

Form ADV

The SEC substantially revised the format and requirements for advisers’ ADV filings in 2012 based on mandates found under the DFA. It is important to reiterate these requirements as failure to abide by them may result in serious consequences.

Every registered investment adviser must update its Form ADV within 90 days of its fiscal year-end. This includes filing all amendments to Part 1A and Part 2A (“Brochure”) of Form ADV with the SEC electronically.

Myles J. Edwards, Esq. is the General Counsel and Chief Compliance Officer for Constellation Wealth Advisors LLC (“CWA”) in New York City. CWA is a multi-billionaire dollar independent multi-family investment office which provides opportunities globally and is registered with the SEC, and is a member of FINRA, MSRB and the NFA. Mr. Edwards is recognized as one of the leading experts in compliance and risk and is a noted speaker and author on this topic. He can be reached directly at [email protected].

Teresa Cooper is the Compliance Associate for Constellation Wealth Advisors LLC (“CWA”) in New York City. Ms. Cooper acts as the primary compliance and registration liaison for the firm’s FINRA, SEC and NFA registrants. Ms. Cooper has also been instrumental in developing the infrastructure for satisfying the firm’s NFA CPO and CTA reporting and recordkeeping requirements.

mailto:[email protected]


Additionally, every registered investment adviser must also deliver Part 2A (or provide a summary of material changes to Part 2A with an offer to provide the Part 2A) to its advisory clients. While Part 2B (the “brochure supplement”) is not required to be filed electronically, a registered investment adviser must complete and deliver one or more “brochure supplement[s]” to its advisory clients, as appropriate. We recommend that a registered investment adviser whose clients are private investment funds deliver its “brochure” and “brochure supplement[s]” to all investors in the funds, as appropriate. The delivery of an adviser’s disclosure documents is both a reporting and recordkeeping requirement because an adviser is required to maintain documentation regarding delivery to its advisory clients.

A registered investment adviser may be required to make a state notice filing in any state in which an adviser has a specified number of clients. Notice filings may be made on Form ADV Part 1A with a deposit of the appropriate state fee(s) into the adviser’s IARD account. As notice filing and investment adviser registration requirements differ from state to state, each adviser should check the requirements for each state in which it operates or has clients (or investors, in certain circumstances).

Form PF

The DFA mandated that the SEC create a process to provide private fund transparency for regulators. Rule 204(b)-1 under the Investment Advisers Act of 1940 requires that SEC registered investment advisers who manage private funds report risk exposure statistics on a consistent basis on Form PF.

As we will examine with CFTC/NFA reporting below, it is very important to define who you are based on the statutory definitions of hedge, private equity and liquidity funds. For our purposes here, we will only examine the requirements for hedge funds.

Large “hedge” fund advisers whose RAUM exceeded $5 billion would have already made their first filing by August 29, 2012. Large “hedge” fund advisers whose RAUM are between $1.5 billion and $5 billion would have made their first filing by March 1, 2013 (assuming a December 31st year end). In both scenarios, the completed FORM PF, Sections 1 & 2 must be filed initially and then subsequently on a quarterly basis based on their year-end electronically through FINRA’s PFRD system.

Smaller “hedge” fund advisers whose RAUM are less than $1.5 billion would have made their first filing by April 30, 2013 (assuming a December 31st year end). After their initial filings, they must subsequently complete Form PF Sections 1a through 1c (Funds of Funds only need to complete Sections 1a and 1b) on an annual basis within 120 days of the end of their fiscal year. Similar to the treatment of the Form ADV, the SEC considers this filing necessary to satisfy both reporting and recordkeeping requirements. Unlike the Form ADV, the Form PF will generally not be publicly available.

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3rd “R” Recordkeeping

The DFA enhanced the recordkeeping requirement for registered investment advisers, especially for those who advise private funds. As a result, advisers to private funds must now maintain (but not necessarily file with the SEC), certain records and reports pertaining to the following items: amount of assets under management; use of leverage (including off-balance-sheet leverage); counterparty exposure; trading and investment positions; valuation policies and practices, types of assets held; side arrangements or side letters; trading practices and other information deemed necessary by the SEC.

Additionally, all records of a private fund maintained by an adviser are subject to periodic and special examination by the SEC. The records subject to examination are not limited to the records required to be kept by law. The DFA directs the SEC to conduct periodic examinations of all records of private funds maintained by an adviser and authorizes it to conduct special examinations as may be necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

CFTC & NFa10

1st “R” Registration

The DFA compelled the U.S. Commodity Futures Trading Commission (“CFTC”) to rescind the exemption from registration as a Commodity Pool Operator (“CPO”)11 and Commodity Trading Advisor (“CTA”)12 relied upon by many Private Funds that may have been previously exempt from registering as a CPO under Rule 4.13(a)(4), and as a CTA under a corollary exemption contained in Rule 4.14(a)(8). To continue to remain exempt from registration, investment advisers (sometimes also referred to as investment managers) as sponsors and advisers to Private Funds must either “stop trading in commodity futures, retail foreign exchange contracts and most swaps” or “limit such trading and seek to qualify under Regulation 4.13(a)(3)13 and file for such exemption with the NFA.” Otherwise, the sponsor should have been registered as a CPO and the adviser registered as a CTA (absent another exemption) by December 31, 2012, and they would then be subject to compliance and disclosure obligations.

Therefore, Private Funds and their sponsors who had previously relied on the unlimited trading exemption provided by Rule 4.13(a)(4) had until December 31, 2012 to become compliant, which meant; (1) relying on another exemption from the requirement to register as a CPO, (2) registering as a CPO and seeking to qualify for relief under Rule 4.7, “CFTC Lite,” from certain disclosure, reporting and recordkeeping requirements or (3) ceasing to operate commodity pools subject to CFTC jurisdiction by either redeeming all U.S. investors or ceasing to trade commodity interests, including exchange traded futures and options on futures and most swaps in transactions anywhere in the world. It should be noted that certain relief has been provided to sponsors of Fund of Funds by the CFTC.14

2nd “R” Reporting

The NFA employs methodology similar to the SEC’s, determining reporting requirements by defining entities by size based on their assets under management.15 For example, a “Large CPO” (and in most cases, the underlying Fund being advised and sponsored is the Pool) has over $1.5 billion Pool Assets under Management (“PAUM”) as of the Reporting Date. Similarly, a “Mid-Size CPO” has between $150 million and $1.5 billion PAUM, and a “Small CPO” has less than $150 million PAUM. Therefore, unlike investment advisers where RAUM below $25 million may not require either federal or state registration, with the NFA everyone is covered regardless of the amount of assets they have under management.

The DFA mandated new filing requirements for firms registered with the CFTC as a CPO and a CTA. For the CPO, there is the annual and quarterly filing of the CPO-PQR. For the CTA, there is the annual filing of the Form CTA-PR (though there is discussion regarding making this requirement quarterly). Form CPO-PQR is divided into three separate schedules and reporting requirements, which are tied to calendar year and quarter ends and which vary depending on the size of the CPO. Therefore, it is imperative to define what “size” CPO you are in order to understand your filing requirements.

Large CPOs would have had to make their initial filing by November 29, 2012, while other CPOs, depending on when their registration date became effective, would have made their initial filings during the first quarter of 2013.16

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Filings will be accomplished electronically though the NFA website and a rule to remember is that all CPOs are required to file the Schedule “A” of the CPO-PQR. Large and Mid-Size CPOs will also have to file the Schedule “B” and only Large CPOs will have to file the Schedule “C.”17 It is important to note that if the entity is also a FORM PF filer, it only needs to complete Schedule “A” of the Form CPO-PQR, and must report a Schedule of Investments quarterly.

CTAs have lighter reporting requirements, as their first quarterly filing of the CTA-PR would have been due on February 14, 2013. The Form CTA-PR is a brief one-page form. Entities that are registered both as a CPO and a CTA must complete Schedule “A” of the Form CTA-PR and complete the applicable schedules of the Form CPO-PQR.

3rd “R” Recordkeeping

A CTA’s and CPO’s recordkeeping will be based upon a number of factors including its size, complexity and business model. Unlike other regulatory schemes, one size does not fit all, and a good place to start is to codify recordkeeping policies and procedures into one source such as a Written Supervisory Procedures (“WSPs”) and Compliance Manual. In the WSPs, the combined CTA and CPO can present the framework for periodic filings protocols, including the quarterly and annual reporting. New NFA registrants must be completely fluent in the requirements they must adhere to predicated upon their exemption from registration or registration itself. The NFA does provide a comprehensive overview of their requirements on its website and points to its own Compliance Rule 2-10 as a starting point. It is suggested that immediately after an entity becomes registered with the NFA, it must subject itself to an internal self-examination18 modeled upon the annual requirements imposed by the NFA. This self-examination may expose critical weaknesses in the registrant’s infrastructure which can be corrected before any on-site inspection occurs. More importantly, this process will validate the firm’s compliance with CFTC and NFA rules and regulations.

Conclusion

Though the Dodd-Frank Act is considered burdensome by many who are subject to it, and though it is sometimes misunderstood by the investors whom it seeks to protect, its provisions will continue to be implemented and will be subject to examination and inspection.

The SEC has recently outlined “best practices” for an adviser operating in a heightened regulatory environment. These practices include “setting the tone at the top,” and developing “narrowly tailored compliance programs” focused toward examination.19 Though these comments were directed at the alternative hedge fund space, they ring true for all entities subject to SEC jurisdiction and validate the “3Rs” approach. These comments mirror those of other regulatory bodies tasked with enforcement of the DFA.

In conclusion, we believe that the “3Rs” provide a methodology to address systematically the DFA requirements, satisfy the business requirements of your respective firm, and result in a position whereby you can successfully withstand regulatory scrutiny and inspection.

This article was written by Myles Edwards and Teresa Cooper and is reprinted with permission from Practical Compliance and Risk Management for the Securities Industry, a professional journal published by Wolters Kluwer Financial Services. The article may not be re-published without permission from Wolters Kluwer Financial Services. Originally published May/June 2013 Wolters Kluwer. ©2013 Wolters Kluwer.

(Endnotes)1 See “Dodd-Frank Wall Street Reform and Consumer Protection Act”, Title IV available at: http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf. Title IV - Regulation of Advisers to Hedge Funds and Others also known as the Private Fund Investment Advisers Registration Act of 2010.

2 Original attribution has been given to Sir William Curtis and first appeared in The Mirror of Literature, Amusement, and Instruction, Volume V, printed and published by J. Limbird, London 1825.

3 It is interesting to note some of the comments expressed during deliberation over Dodd-Frank included: “Years without accountability for Wall Street and big banks brought us the worst financial crisis since the Great Depression, the loss of 8 million jobs, failed businesses, a drop in housing prices, and wiped out personal savings. The failures that led to this crisis require bold action. We must restore responsibility and accountability in our financial system to give Americans confidence that there is a system in place that works for and protects them. We must create a sound foundation to grow the economy and create jobs.” http://banking.senate.gov/public/_files/070110_Dodd_Frank_Wall_Street_Reform_comprehensive_summary_Final.pdf.

4 Officially known as “The Banking Act of 1933” (Pub.L. 73–66, 48 Stat. 162, enacted June 16, 1933), Glass-Steagall was codified under Sections 16, 20, 21 and 32 of this Act.

5 See “Repeal of Glass - Steagall Caused the Financial Crisis,” by James Rickards, August 27, 2012, U.S. News & World Report on line. Available at: http://www.usnews.com/opinion/blogs/economic-intelligence/2012/08/27/repeal-of-glass-steagall-caused-the-financial-crisis

6 During the 2009 House of Representatives consideration of H.R. 4173, the bill that became the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Representative Maurice Hinchey (D-NY) proposed an amendment to the bill that would have reenacted Glass–Steagall Sections 20 and 32 and also prohibited bank insurance activities. The amendment was not voted on by the House.

7 RAUM is defined by the formula found under Item 5.F: Calculating Your Regulatory Assets under Management, as found under the FORM ADV: Instructions for Part 1A, page 7.

8 The DFA defines the term “private fund” to be any fund that would be an investment company but for the exemptions contained in Section 3(c)(1) or 3(c)(7) of the Investment Company Act. This definition is similar to the Volcker Rule definition of “hedge fund” and “private equity fund,” which covers an issuer that would be an investment company but for the exemptions contained in Section 3(c)(1) or 3(c)(7) of the Investment Company Act, or such similar funds as the appropriate federal banking agencies, the SEC and the CFTC may, by rule, determine. Generally, 3(c)1 Funds have 100 or fewer investors while 3(c)7 Funds have exclusively “qualified purchasers” as investors who are generally individuals that own “Investments” of at least $5,000,000 or entities [other than family-owned companies] that own “Investments” of at least $25,000,000.

http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf

http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf

http://en.wikipedia.org/wiki/Private_Fund_Investment_Advisers_Registration_Act_of_2010

http://banking.senate.gov/public/_files/070110_Dodd_Frank_Wall_Street_Reform_comprehensive_summary_Final.pdf



http://en.wikipedia.org/wiki/United_States_Statutes_at_Large

http://en.wikipedia.org/wiki/Dodd-Frank_Wall_Street_Reform_and_Consumer_Protection_Act_of_2010

http://en.wikipedia.org/wiki/Dodd-Frank_Wall_Street_Reform_and_Consumer_Protection_Act_of_2010

http://en.wikipedia.org/wiki/Maurice_Hinchey


9 Family Offices excluded from the Advisers Act regulation are any companies that provide investment advice only to “family clients,” as defined by the rule, is wholly owned by family clients and is exclusively controlled by family members and/or family entities, as defined by the rule and does not hold itself out to the public as an investment adviser. See 17 CFR Part 275, [Release No. IA-3220; File No. S7-25-10] available at http://www.sec.gov/rules/final/2011/ia-3220.pdf.

10 National Futures Association is the Self-Regulatory Organization for the U.S. futures industry and may be contacted through http://www.nfa.futures.org/.

11 A commodity pool is a commingled investment vehicle that invests in commodity interests. A commodity pool that invests in other commodity pools is a commodity pool itself (e.g. fund of funds). Each commodity pool must have at least one CPO and one CTA. In most cases, the CPO and the CTA will be the same entity that is the investment manager and or adviser and sponsor to the Private Fund(s).

12 A CTA advises the commodity pool with respect to the trading of, or the advisability of trading in, commodity interests. The investment adviser to a private fund (like each Fund) may serve as both the CPO and CTA. In a fund-of-funds whereby a fund invests in other commodity pools or in a manager-of-managers arrangement, the entity that allocates assets to the underlying commodity pools or to the other CTAs, respectively, is acting as a CTA.

13 Rule 4.13(a)(3) exempts from CPO registration the operator of a commodity pool if interests in the pool are exempt from registration under U.S. Securities Act of 1933 (the “Securities Act”) and are not marketed to the public in the United States and where the pool’s use of commodity interests is very limited, (In this instance, “very limited” means either: (a) that the pool’s aggregate initial margin and premiums attributable to commodity options and commodity futures, respectively, do not exceed 5% of the liquidation value of the pool’s portfolio after taking into account unrealized profits and unrealized losses on any such positions it has entered into, provided that, in the case of an option that is in-the-money at the time of purchase, the in-the-money amount may be excluded in computing such 5%; or (b) that the aggregate net notional value of such positions does not exceed 100% of the liquidation value of the pool’s portfolio after taking into account unrealized profits and unrealized losses on any such positions it has entered into. Both tests do not differentiate as to whether the positions are held for bona fide hedging purposes or otherwise, 17 C.F.R. § 4.13(a)(3)(ii)) and the interests are offered only to accredited investors. Other exemptions from registration that may be available are Rule 30.4 which exempts from CPO registration the operators of non-U.S. investment pools, provided that (i) the pool does not transact future contracts or options on any U.S. futures markets, (ii) the pool is exempt from registration under the U.S. Investment Company Act of 1940 and the pool’s securities are exempt from registration under the Securities Act; and (iii) no more than 10% of the participants in or values of the assets of the pool are held by U.S. investors; or Rule 30.5 which exempts from CPO registration the operators of non-U.S. investment pools, provided that, among other things, (i) the pool does not transact future contracts or options on any U.S. futures markets, (ii) the operator files a petition with the NFA representing that it is located outside the United States and does not engage in trading on U.S. futures markets for its U.S. clients and agrees to submit to U.S. jurisdiction, and (iii) the operator enters into a written agreement appointing a U.S. entity as agent for service of process.

14 On November 29, 2012, the CFTC issued a no-action letter providing time-limited relief to the operators of funds of funds facing the prospect of registration with the CFTC prior to December 31, 2012 as a result of the rescission of Rule 4.13(a)(4) and amendments to Rule

4.5 See CFTC No-Action Letter No. 12-38 (Nov. 29, 2012). The letter provides that the Division of Swap Dealer and Intermediary Oversight (the “Division”) will not recommend that the CFTC take enforcement action against the manager of a fund of funds for failure to register as a commodity pool operator (“CPO”) until the later of June 30, 2013, or six months after the effective date (or compliance date, if later) of any revised guidance that the Division issues on the application to fund of funds managers of the de minimis thresholds in CFTC Rule 4.5 and Rule 4.13(a)(3) See 77 Fed. Reg. 11252 (Feb. 24, 2012); correction Fed. Reg. 17328 (Mar. 26, 2012).

15 The SEC and CFTC use different methods for determining AUM; the CFTC requires the use of aggregated gross pool assets that are under a CPO’s control whereas the SEC uses “regulatory assets under management” which is the gross value of the securities portfolios and private funds managed by an adviser as calculated for Form ADV. The asset test for Form PF applies to AUM on the period end date whereas the asset test for CPO-PQR applies if the AUM threshold has been crossed on any particular day during the reporting period. This may result in a manager being in one category for SEC purposes and a non-corresponding tier for CFTC purposes. Given the various substitution and timing deadlines summarized previously, this may lead to complexity when managing a manager’s reporting obligations.

16 A synopsis of these dates would be as follows; Registered CPOs with at least $5 billion AUM as of June 30, 2012 must have filed by November 29, 2012. Registered CPOs with between $1.5 billion and $5 billion AUM in commodity pools must have filed by March 1, 2013 with respect to the year-ended December 31, 2012. Registered CPOs with between $150 million and $1.5 billion AUM must have filed by April 1, 2013 with respect to the year-ended December 31, 2012. Registered CPOs with less than $150 million AUM must have filed by April 1, 2013 with respect to the year-ended December 31, 2012.

17 A synopsis of these filings would be as follows; for a Large CPO, the Form CPO-PQR Schedules A, B, C filed Quarterly within 60 days of quarter end (If it uses the Form PF to substitute for the Schedules B and C, then it must file the NFA Schedule of Investments). For a Mid-Size CPO, it must file the Form CPO-PQR Schedule A plus the NFA Schedule of Investments Quarterly within 60 days of quarter-end and annually within 90 days of year-end (If it uses the Form PF to substitute for the Schedule B for the annual filing, then it must file the NFA Schedule of Investments). For a Small CPO it must file the Form CPO-PQR Schedule A plus the NFA Schedule of Investments Quarterly within 60 days of quarter-end; and annually within 90 days of year-end.

18 The NFA’s self-examination questionnaires are found at http://www.nfa.futures.org/NFA-compliance/publication-library/self-exam-questionnaire.HTML.

19 See Enforcement Priorities in the Alternative Space a speech by Bruce Karpati, Chief, SEC Enforcement Division’s Asset Management Unit, U.S. Securities and Exchange Commission given Before the Regulatory Compliance Association, New York, New York on December 18, 2012. The entire speech can be obtained at http://www.sec.gov/news/speech/2012/spch121812bk.htm. A complement to this speech is the announcement of the SEC’s Division of Investment Management’s top regulatory initiatives by Norm Champ its Director. This speech was delivered at the Practicing Law Institute’s conference, “The SEC Speaks in 2013” held on February 22, 2013 in Washington, D.C.

http://www.sec.gov/rules/final/2011/ia-3220.pdf

http://www.sec.gov/rules/final/2011/ia-3220.pdf

http://www.nfa.futures.org/

http://www.nfa.futures.org/NFA-compliance/publication-library/self-exam-questionnaire.HTML



http://www.sec.gov/news/speech/2012/spch121812bk.htm

http://www.sec.gov/news/speech/2012/spch121812bk.htm


Life After CPO Registration: A Look at Several Significant CFTC and NFA Compliance Obligations that Lie Ahead for this Year’s Bumper Crop of Newly Registered CPOs*By Sean Finley, Nathan Greene, Jared Gianatasio, and Zachary Bodmer**

Introduction

Over the last few months, an exceptional number of investment management firms have either registered or prepared to register with the Commodity Futures Trading Commission (“CFTC”) as “commodity pool operators” (“CPOs”). Many of these firms, which operate investment funds (or “pools”) that participate directly or indirectly in CFTC-regulated “commodity interests” (such as commodity futures contracts, options on such contracts, and swaps), have been goaded toward registration by 2012 CFTC rulemaking that greatly narrowed the scope of registration relief historically available to CPOs. Since January 1st of this year, when much of that rulemaking was implemented, CPO registration has become all but mandatory for most U.S. managers of hedge funds, mutual funds, and various other types of pools that engage in more than de minimis levels of commodity interest trading.

Newly registered CPOs likely will need to weave into their compliance programs numerous policies and procedures dictated by the rules of the CFTC and the National Futures Association (“NFA”).31 This article highlights several of the more significant areas in which the CFTC and NFA regulate CPOs, and a number of particular requirements that recent CPO registrants should ensure they have accounted for in preparing for life with their new regulators. This article also highlights certain significant regulatory relief that some CPOs may be able to claim, particularly with respect to their CFTC disclosure, reporting, and recordkeeping obligations.

* * *

1. Duty to Update Registration Forms

CPOs generally must ensure that the identification information, disciplinary history, contact details, and other information contained in their CPO registration form—CFTC/NFA Form 7-R—remains current. Specifically, CFTC Rule 3.31 and NFA Registration Rule 210 require that all CPO applicants and registrants “promptly” correct any deficiency or inaccuracy in the information contained in their Form 7-R. Although it is unclear how quickly a correction generally must be made to have been made “promptly,” NFA Registration Rule 208 specifically requires an NFA member to update its Form 7-R to reflect the addition of any new president, chief financial officer, or other “principal” of the member within 20 days after the applicable addition.

In addition to requiring CPOs to maintain the accuracy of their Form 7-R, Registration Rule 210 requires that all CPO applicants and registrants promptly correct any deficiency or inaccuracy in the information contained in each CFTC/NFA Form 8-R used to list the CPO’s principals and to register the CPO’s “associated persons” (i.e., any marketer, or any person who directly or indirectly supervises any marketer, for a CPO). Consequently, a CPO should ensure that each of its principals and associated persons is familiar with this obligation, and with their corresponding obligation to update appropriate personnel at the firm, no later than the submission of the applicable individual’s Form 8-R.

2. Pool Disclosure Documents

CFTC Rules 4.21, 4.24, 4.25, and 4.26 generally impose

Sean Finley is a partner in Shearman & Sterling LLP’s Asset Management Group, with extensive experience advising investment management firms on CFTC regulatory and compliance matters. Mr. Finley also assists clients with SEC compliance matters, private fund formation, and various legal and operational matters related to the management and investment activities of private funds and their sponsors and advisers.

Nathan Greene is a partner and Co-Practice Group Leader in the Asset Management Group at Shearman & Sterling LLP. Mr. Greene advises on all regulatory aspects of fund and investment advisory operations. His practice includes the formation and representation of U.S. and non-U.S. investment companies, their sponsors, advisers, directors, and marketers.

Jared Gianatasio is a senior associate in the Asset Management Group of Shearman & Sterling LLP. Mr. Gianatasio advises on a variety of investment management matters, including CFTC compliance matters. Mr. Gianatasio also advises market participants on a number of derivatives regulatory and risk management issues, including various regulatory and compliance issues stemming from the Dodd-Frank Act.

Zachary Bodmer is an associate in the Asset Management Group of Shearman & Sterling LLP. Mr. Bodmer’s practice primarily focusses on assisting fund sponsors with the structuring and formation of hedge funds and private equity funds in both the United States and offshore jurisdictions. Mr. Bodmer also advises on CFTC and SEC compliance matters.


extensive disclosure obligations on registered CPOs, requiring them to prepare, electronically file with the NFA, and provide to prospective investors a prescribed form of pool disclosure document. Other CFTC Rules and positions of the CFTC staff offer potential relief from such requirements, including CFTC Rule 4.7 relief discussed below.

Disclosure Document Content

CPOs required to prepare a pool disclosure document likely will find that several disclosure items required by Rule 4.24 are ones that they would have furnished to investors in any event. These include:

• discussions of the principal risks associated with investing in the pool;

• the business background of certain key principals of the CPO;

• information relating to the fees and expenses borne by the pool; and

• details of the pool’s policies concerning redemptions and transfers of pool interests.

However, Rule 4.24 also prescribes several disclosure items that many CPOs likely would not have thought to include in their offering memorandum for a pool, either at all or to the level of detail prescribed by Rule 4.24. These include:

• the amount of any interest in the pool owned by the CPO or any of its principals;

• the past performance information specified in Rule 4.25;

• material litigation (whether ongoing or concluded within the last five years) concerning the CPO and any of its principals; and

• the amount of trading profit that the pool must realize in the first year of an investor’s investment to equal all fees and expenses such that the investor will recoup its initial investment (referred to as the investor’s “break-even point”).

Distribution and Filing Requirements

CFTC Rule 4.21 generally requires a CPO to provide a pool’s disclosure document to a prospective investor by no later than the time that the CPO first delivers to the investor a subscription agreement for the pool. Rule 4.21 also generally prohibits a CPO from accepting an investor’s investment in a pool unless the CPO has received from the investor an acknowledgment signed and dated by the investor, stating that the investor has received the pool’s disclosure document.

CFTC Rule 4.26 generally requires CPOs to electronically file their pool disclosure documents with the NFA at least 21 days prior to the date that they first intend to deliver them to a prospective investor. Similarly, if a CPO knows or should know

that a disclosure document has become materially inaccurate or incomplete in any respect, Rule 4.26 requires a CPO to amend the document to cure the defect and to electronically file the amendment or revised document with the NFA and distribute it to all existing pool participants, in each case, within 21 days after the date that the CPO first knew or should have known of the defect requiring the amendment. Additionally, if a pool is continually offered, Rule 4.26 requires its CPO to update the pool’s disclosure document at least every nine months and electronically file the updated document with the NFA at least 21 days prior to first use.

If interests in a pool are offered or sold exclusively to “accredited investors” (as defined in Regulation D under the Securities Act of 1933 (“Securities Act”)), CFTC Rule 4.8 permits a CPO to bypass the above-noted 21-day waiting periods, and to use a disclosure document immediately upon filing it with the NFA.

Rule 4.7 Regulatory Relief

CPOs wishing to avoid the CFTC’s disclosure document regime may seek various forms of relief from it. Perhaps the most popular form of relief is that available under CFTC Rule 4.7. Rule 4.7 generally permits a CPO to bypass the disclosure document regime for a pool if the pool will (i) offer its interests solely pursuant to the Section 4(a)(2) private offering exemption from registration under the Securities Act, and/or pursuant to Regulation S under that Act, and (ii) limit the offer or sale of its interests solely to persons who meet the standards of a “qualified eligible person” (“QEP”) under Rule 4.7. There are numerous ways in which an investor can meet the QEP standard, including if it both (i) is an accredited investor and (ii) owns securities with an aggregate market value of at least $2,000,000. A CPO seeking to rely on Rule 4.7 must claim the relief on a pool-by-pool basis, and must provide prospective pool investors with a prescribed form of notice.

Other forms of relief from the CFTC’s disclosure document regime (as well as certain CPO reporting and recordkeeping requirements discussed below) are also potentially available to CPOs. These include (i) broad relief with respect to certain pools that have limited U.S. jurisdictional contacts (relief available pursuant to CFTC Advisory 18-96), and (ii) narrower relief with respect to certain pools that limit the extent to which they trade in commodity interests (relief available pursuant to CFTC Rule 4.12).

anti-Fraud Considerations

It is important to note that all CPOs (even those that may rely on Rule 4.7 or are exempt from registration altogether) remain subject to certain general anti-fraud provisions of the Commodity Exchange Act, including Section 4o of that Act, which effectively prohibits CPOs from making fraudulent or deceitful statements or omissions in connection with their offerings of pool interests. Accordingly, while applicable commodity laws and rules may impose no affirmative duty on a CPO to furnish a disclosure document to investors in a Rule 4.7 pool, a CPO electing to


rely on Rule 4.7 should strongly consider furnishing prospective investors with a comprehensive offering memorandum for the benefits it may hold in preempting offering-related fraud claims.

3. Periodic Reporting to Investors

CFTC rules generally require registered CPOs to provide to their pool investors two forms of periodic reporting: monthly or quarterly account statements, and annual reports.

Periodic account Statements

Statement Content

CFTC Rule 4.22 generally requires CPOs to distribute periodically to each investor in their pools a prescribed account statement containing both a statement of operations and a statement of changes in net assets for the applicable reporting period. The statement of operations must separately itemize, among other things, the total amounts of all advisory fees, brokerage commissions, and other fees paid by the pool during the applicable period, as well as details of the pool’s realized and unrealized gains and losses from commodity interest and other transactions effected during the period. The statement of changes in net assets must separately itemize:

• the net asset value of the pool as of the beginning and end of the applicable period;

• the value of all subscriptions to, and all withdrawals from, the pool during the period;

• the total net income or loss of the pool during the period; and

• the net asset value per outstanding unit of interest in the pool (or the total value of the investor’s interest in the pool) as of the end of the period.

For pools that have multiple classes of interests outstanding, these statements generally must specify the relevant items for the class of interests held by the investor and, separately, for the pool as a whole. Statements generally also must be presented and computed in accordance with GAAP, consistently applied (or, under certain conditions, in accordance with International Financial Reporting Standards), and must include a manually signed oath or affirmation that, to the best of the knowledge and belief of the individual making the oath or affirmation, the information contained in the statement is accurate and complete.

Distribution Requirements

CPOs generally must distribute periodic account statements to investors at least monthly or, if a pool’s net asset value did not exceed $500,000 at the beginning of its most recent fiscal year, quarterly and, in either case, within 30 days after the end of the applicable reporting period. CPOs wishing to deliver account statements electronically may do so, but only after having obtained investors’ consent to such delivery. CFTC Rule

4.22(i) conveniently permits a CPO to obtain such consent from an investor negatively if the CPO discloses to the investor its intention to electronically deliver such statements and the investor does not object to the notice within ten business days after receiving it.


As with the prescribed content of pool disclosure documents noted above, CPOs required to distribute a Rule 4.22 account statement likely will find that several items of information required by the Rule are ones that they would have furnished to investors with the requisite frequency in any event. Other content, however, including the separate itemization of certain pool expenses, is less likely to be provided to investors as a matter of course, and likely will require related enhancements to a fund manager’s reporting procedures. CPOs that wish to minimize or avoid such additional reporting obligations may do so by claiming certain regulatory relief referenced above, including the relief available pursuant to CFTC Rule 4.7.

A CPO claiming Rule 4.7 relief with respect to a pool may distribute to each investor in that pool, in lieu of the monthly statement of operations and statement of changes in net assets noted above, a quarterly account statement indicating:

• the net asset value of the pool as of the end of the reporting period;

• the change in net asset value from the end of the previous reporting period; and

• the net asset value per outstanding unit of participation in the pool (or the total value of the investor’s interest in the pool) as of the end of the reporting period.

In the case of a multi-class pool, such Rule 4.7 account statements must specify the relevant items for the class of interests held by the investor and, separately, for the pool as a whole. Rule 4.7 statements also must include the above-referenced oath or affirmation required of non-4.7 pool statements, and must be presented and computed in accordance with GAAP (or, under certain conditions, in accordance with International Financial Reporting Standards).

annual Reports

Report Content

CFTC Rule 4.22 also generally requires CPOs to distribute to each investor in a pool an annual report for the pool. The annual report must include a statement of financial condition, a statement of changes in net assets, and a statement of operations for the fiscal year, and must include similar information relating to one or, in certain cases, more of the pool’s immediately preceding fiscal years. For pools that have multiple classes of interests outstanding, the report generally must include the relevant items for the class of interests held by the investor and,


separately, for the pool as a whole. Rule 4.22 further requires that, if the pool is structured as a fund of funds, the annual report generally must state the income and investment advisory fees associated with each of its sub-funds separately or, for all sub-funds representing less than five percent of the fund of fund’s net assets, on a consolidated basis. The annual report also must include appropriate footnote disclosure and other material information.

Like account statements, annual reports must be presented and computed in accordance with GAAP, consistently applied (or, under certain conditions, in accordance with International Financial Reporting Standards), and must include a manually signed oath or affirmation as to their accuracy and completeness. Unlike account statements, annual reports must be audited and certified by an independent public accountant.

Distribution and Filing Requirements

A CPO generally must distribute a pool’s annual report to investors within 90 days after the end of the pool’s fiscal year or the pool’s permanent cessation of trading (whichever is earlier). For many CPOs, particularly CPOs of funds of funds, this 90-day delivery window may prove impracticable. The 90-day delivery window also represents a significant reduction of the 120-day period during which investment advisers registered with the Securities and Exchange Commission (“SEC”) are generally permitted to deliver a fund’s annual report under the SEC’s investment adviser “custody rule.”

Rule 4.22(f ) offers CPOs two potential means of extending the 90-day delivery window:

• Rule 4.22(f )(1) provides that if a CPO is unable to distribute the annual report for a pool within the 90-day timeframe without substantial undue hardship, it may file with the NFA an application for an extension that is not more than 90 days after the date as of which the annual report was to be distributed. The application must state, among other things, the reason for the requested extension and, if applicable, that the circumstances requiring the extension are beyond the control of the CPO and a brief description of such circumstances. The application also must include a letter from the pool’s independent public accountant explaining the reasons for the request and whether the accountant has any reason to believe that the CPO is not in compliance with its recordkeeping obligations under applicable CFTC Rules or with its obligation under CFTC Rule 4.20 to not commingle the property of the pool with the property of any other person.

• Rule 4.22(f )(2) provides that if a CPO is unable to obtain the necessary information to comply with the 90-day timeframe as a result of its pool investing in another collective investment vehicle, the CPO may claim an extension by filing with the NFA a notice within 90 days

after the end of the pool’s fiscal year. The notice must state the date that the annual report will be distributed to investors and filed with the NFA, and must contain several representations by the CPO, including a representation that certain information specified by the pool’s auditor cannot be obtained in sufficient time for the annual report to be prepared, audited, and distributed before the specified extension date. The specified extension date can be no more than 180 days after the end of the pool’s fiscal year.

Like account statements, CPOs may deliver annual reports to investors electronically, subject to the consent requirement of Rule 4.22(i). Unlike account statements, however, a CPO generally must also file with the NFA (electronically) a copy of each of its pool’s annual reports.


A CPO claiming Rule 4.7 relief with respect to a pool may distribute to each investor in the pool, and electronically file with the NFA, in lieu of an annual report described in Rule 4.22, a certified annual report that includes:

• a statement of financial condition as of the close of the fiscal year;

• a statement of operations for that year;

• appropriate footnote disclosure and any other material information; and

• a statement that the pool is an exempt pool under CFTC Rule 4.7.

Rule 4.7 pool annual reports are subject to the same GAAP, certification, timing, oath, class-specific information, sub-fund information, and NFA filing requirements noted above with respect to non-4.7 pool annual reports.

4. Periodic Reporting to the NFa

Apart from the requirement to file with the NFA annual reports for its pools, a registered CPO generally must file two periodic reports with the NFA: CFTC Form CPO-PQR and NFA Form PQR.

CFTC Form CPO-PQR

Filing Framework

CFTC Rule 4.27 requires that CPOs periodically file electronically with the NFA certain systemic-risk-related reports on CFTC Form CPO-PQR. Form CPO-PQR consists of three Schedules—A, B, and C. A CPO must file one or more of these Schedules with the frequency, and within the timeframes, specified in the chart below, based primarily on whether the amount of the CPO’s “aggregated gross pool assets under management” (“AUM”) renders the CPO a “small,” “mid-sized,” or “large” CPO.


CPO Size* Schedule A Schedule B Schedule CLarge CPO

(AUM > $1.5B as of the close of business of any day during the most recent calendar quarter)

Quarterly within 60 days of the close of the most recent calendar quarter.


Must file a separate Schedule B for each pool operated during the quarter.


Must file a separate Part 2 of Schedule C for each pool operated during the quarter that had a net asset value (“NAV”) > $500M* as of the close of business of any day during the quarter (“Large Pool”).

Mid-sized CPO

($1.5B > AUM > $150M as of the close of business of any day during the most recent calendar year)

Annually within 90 days of the close of the most recent calendar year.


Must file a separate Schedule B for each pool that it operated during the most recent calendar year.

Not required.

Small CPO

(AUM < $150M as of the close of business of any day during the most recent calendar year)


Not required. Not required.

* The instructions to Form CPO-PQR include several rules for determining a CPO’s AUM, and a pool’s NAV, that are not included in this chart. CPOs should consult the Form’s instructions for guidance.

A CPO that is also registered with the SEC as an investment adviser generally can satisfy its obligation to file Schedules B and/or C for the reporting period in question by, in the case of Schedule B, including in Sections 1.b and 1.c of Form PF the applicable information for each of its pools, and, in the case of Schedule C, including in Section 2 of Form PF the applicable information for each of its pools and Large Pools (as defined in the table above), as applicable. However, because Form PF reporting periods are tied to an investment adviser’s fiscal year and Form CPO-PQR reporting periods are tied to the calendar year, the extent to which an investment adviser/CPO can benefit from such reporting reciprocity may be limited if it has elected a fiscal year other than the calendar year.

Filing Content

Schedule A requests relatively basic identification and operational information about a CPO and each pool it operates, including, among other things:

• the identity of certain service providers to the pool;

• the pool’s monthly rates of return; and

• the value of subscriptions to, and redemptions from, the pool during the reporting period.

Schedule B requests significantly more detailed information about each pool operated by the CPO, including, among other things:

• the extent to which the pool pursues various investment strategies (as a percentage of the pool’s NAV);

• information about the pool’s borrowing activities, types of creditors, counterparty credit exposure, and clearing mechanisms; and

• the dollar value of the pool’s positions in various categories and sub-categories of investments, including a schedule of any individual investments having a value greater than or equal to five percent of the pool’s NAV.

Schedule C requests aggregated information for all pools operated by the CPO (including classification of the pools’ investments by geographic sector and the turnover rate for the pools’ portfolios), and additional information about each Large Pool operated by the CPO, including, among other things:

• the liquidity and various risk metrics of the Large Pool’s portfolio;

• additional details of the Large Pool’s borrowing activities and counterparty credit exposure; and

• the dollar value of the Large Pool’s derivatives positions and collateral posted in relation to those positions.

NFa Form PQR

NFA Compliance Rule 2-46 generally requires that CPOs electronically file with the NFA, within 45 days after the end of each calendar quarter, NFA Form PQR. Form PQR requires a CPO to report for each pool for which it has a reporting obligation under CFTC Rule 4.22 the following information:

• the identity of the pool’s administrator, carrying broker(s), trading manager(s) and custodian(s);

• a statement of changes in NAV for the quarterly reporting period;

• monthly rates of return for the three months comprising the quarterly reporting period; and

• a schedule of investments identifying each investment that exceeds 10% of the pool’s NAV at the end of the quarterly reporting period.

The NFA has proposed extensive amendments to Compliance Rule 2-46 that are intended to harmonize and reduce duplication of Form PQR’s requirements with the requirements of CFTC Form CPO-PQR. These amendments would, among other things:


• revise Form PQR to consist of (i) Schedule A of Form CPO-PQR and (ii) the schedule of investments required by Schedule B of Form CPO-PQR;

• allow small and mid-sized CPOs to file Form PQR within 60 days after the end of each of the first three calendar quarters of each year, and within 90 days after the end of the fourth calendar quarter of each year; and

• allow large CPOs to satisfy their Form PQR filing obligations simply by filing their required Form CPO-PQR schedules within 60 days after the end of each calendar quarter.

5. Recordkeeping

CFTC Rule 4.23 generally requires a registered CPO to make and keep numerous categories of books and records in an accurate, current, and orderly manner at its main business office.

Required Books and Records

A CPO’s recordkeeping obligations extend both to books and records regarding a CPO’s pools and books and records regarding the business of the CPO itself. Required books and records regarding each pool include, among other things:

• itemized daily records of each commodity interest transaction of the pool, showing various prescribed details of each transaction;

• a journal of original entry or other equivalent record showing all receipts and disbursements of money, securities, and other property;

• a subsidiary ledger or other equivalent record for each investor in the pool showing the investor’s name and address and all funds, securities, and other property that the pool received from or distributed to the investor;

• a general ledger or other equivalent record containing details of all asset, liability, capital, income, and expense accounts;

• copies of each confirmation or acknowledgment of a commodity interest transaction of the pool, and each purchase and sale statement and each monthly statement for the pool received from a futures commission merchant, retail foreign exchange dealer, or swap dealer;

• cancelled checks, bank statements, journals, ledgers, invoices, computer generated records, and all other records, data, and memoranda prepared or received in connection with the operation of the pool;

• the original or a copy of each report, letter, circular, memorandum, publication, writing, advertisement or other literature or advice (including the texts of standardized oral presentations and of radio, television, seminar or similar mass media presentations) distributed or caused to be distributed by the CPO to any existing or prospective pool investor or received by the CPO from any commodity trading advisor of the pool, showing the first date of distribution or receipt if not otherwise shown on the document; and

• copies of the financial reporting information required by Rule 4.22, including manually signed copies of each required account statement and annual report.

• Required books and records regarding the business of the CPO itself include, among other things:

• itemized daily records of each commodity interest transaction of the CPO and each of its principals, showing various prescribed details of each transaction;

• each confirmation of a commodity interest transaction, each purchase and sale statement, and each monthly statement furnished by a futures commission merchant or retail foreign exchange dealer to (i) the CPO relating to a personal account of the CPO, and (ii) each principal of the CPO relating to a personal account of such principal; and

• books and records of all other transactions in all other activities in which the CPO engages. Those books and records must include cancelled checks, bank statements, journals, ledgers, invoices, computer generated records, and all other records, data, and memoranda that have been prepared in the course of engaging in those activities.

Recordkeeping Procedures

CFTC Rule 1.31 generally requires CPOs to keep required books and records for a period of five years from the date such records were made, and to keep them readily accessible during the first two years of the five-year period (standards that SEC-registered investment advisers will recognize well). However, CPOs that trade, or that permit their pools to trade, in any swap or related cash or forward transaction should note that records relating to such transactions must be preserved for potentially longer periods—until the termination, maturity, expiration, transfer, assignment, or novation date of any such transaction and for a period of five years after such date.

All such books and records must be open to inspection by any representative of the CFTC or the Department of Justice, and, with the exception of books and records relating to particular investors or to the business of the CPO itself, must be made available to pool investors for inspection and copying during normal business hours at the main business office of the CPO. Upon the request of a pool investor, a CPO also must send copies of records to the investor by mail, within five business days, if reasonable reproduction and distribution costs are paid by the investor.


CPOs that have claimed Rule 4.7 regulatory relief are not required to make and keep the specific books and records prescribed by Rule 4.23. Such CPOs are, however, required to maintain at their main business address copies of the account statements and annual reports that they are required to distribute to investors under Rule 4.7, and all other books and records prepared in connection with their activities as the CPO of a Rule 4.7 pool (including, among other things, records relating to the qualifications of QEPs and substantiating any performance representations). CPOs of Rule 4.7 pools must preserve such


books and records for the same time periods, and must make them available to any representative of the CFTC, the NFA, and the Department of Justice, as noted above with respect to non-4.7 pools.

6. advertising and Promotional Material

When reviewing the adequacy of its compliance program, a registered CPO also must be mindful of the CFTC’s and NFA’s rules relating to advertising and promotional material. Below is a summary of certain standards and requirements included in the CFTC’s and NFA’s two principal rules governing CPO advertising and promotional material—CFTC Rule 4.41 and NFA Compliance Rule 2-29.

CFTC Rule 4.41

General Standards

CFTC Rule 4.41 broadly prohibits CPOs from advertising in any manner that (i) employs any device, scheme, or artifice to defraud any pool investor or prospective pool investor, or (ii) involves any transaction, practice, or course of business that operates as a fraud or deceit upon any pool investor or prospective pool investor. For these purposes an advertisement generally includes any publication, distribution or broadcast of any report, letter, circular, memorandum, publication, writing, advertisement, or other literature or advice, whether by electronic media or otherwise. CPOs that are also subject to the Investment Advisers Act of 1940 (“Advisers Act”) will recognize these general prohibitions as substantively identical to the standards of conduct to which they are subject with respect to their clients and prospective clients under Section 206(1) and (2) of that Act.

Specific Prohibitions

Beyond its general prohibition against fraudulent and deceptive advertising practices, Rule 4.41 specifically prohibits the use of any “testimonial” (in general, any third-party statement that could be viewed as endorsing a CPO) unless certain conditions are met. Specifically, Rule 4.41 prohibits a CPO from referring to any testimonial unless the advertisement or material providing the testimonial prominently discloses:

• that the testimonial may not be representative of the experience of other investors;

• that the testimonial is no guarantee of future performance or success; and

• if more than a nominal sum is paid for the testimonial, the fact that it is a paid testimonial.

CPOs that are also subject to the Advisers Act are unlikely to be able to use testimonials in any event given the SEC’s general prohibition against the use of testimonials.

Rule 4.41 also specifically prohibits a CPO from using any presentation of hypothetical performance for a commodity pool unless the presentation includes a prescribed cautionary statement included in Rule 4.41 or in NFA Compliance Rule 2-29 (discussed below). This statement must be prominently disclosed and in “immediate proximity to” (generally on the same

page as) the presentation of performance. For these purposes, performance generally will be regarded as “hypothetical” if any trading activity factored into the performance figure has not in fact occurred. Importantly, in the view of the NFA, performance also should be regarded as hypothetical—even if it relates solely to actual trading activity—if the performance results portray the composite performance that could have been achieved if assets of the pool had been (but in fact were not) allocated to multiple different trading programs during the performance period.

NFa Compliance Rule 2-29

Like CFTC Rule 4.41, NFA Compliance Rule 2-29 includes both general standards of conduct to which NFA members are subject and certain more-specific requirements concerning the use of “promotional material” (in general, any advertisement concerning or soliciting a commodity interest account, agreement, or transaction).

General Standards

Rule 2-29’s general standards of conduct prohibit an NFA member from engaging in any communication that:

• operates as a fraud or deceit;

• employs or is part of a high-pressure approach; or

• makes any statement that commodity interest trading is appropriate for all persons.

These standards apply both to a member’s use of promotional material and any of its other communications with the public.

Specific Requirements

Rule 2-29’s requirements with respect to promotional material also prohibit a member from using any promotional material that:

• is likely to deceive the public;

• contains any material misstatement of fact or contains any statement that the member knows omits a fact, the omission of which renders the promotional material misleading;

• mentions the possibility of profit unless accompanied by an equally prominent statement of the risk of loss;

• includes any reference to actual past trading profits without mentioning that past results are not necessarily indicative of future results;

• includes any statement of opinion, unless the opinion is clearly identifiable as such and has a reasonable basis in fact; or

• includes any specific numerical or statistical information about the past performance of any actual accounts (including rate of return) unless:

• such information is, and can be demonstrated to NFA to be, representative of the actual performance for the same time period of all reasonably comparable accounts; and


• in the case of rate of return figures, such figures are calculated in a manner consistent with CFTC Rule 4.25(a)(7).

Regarding the use of hypothetical performance information, Rule 2-29 generally also:

• · requires members to include one or more prescribed disclaimers in addition to, or in lieu of, the cautionary statement required by CFTC Rule 4.41; and

• · prohibits members from using promotional material that makes any reference to hypothetical performance results that could have been achieved had a particular trading system of the member been employed in the past if the member has three months of actual trading results for that system.

Importantly, however, these additional requirements relating to hypothetical performance do not apply if the member directs the relevant promotional material solely to persons that are QEPs (although, in such cases, a member must still observe its related cautionary statement obligations under Rule 4.41, described above).

Rule 2-29 further requires members to adopt and enforce written procedures for supervising their employees and associated persons for compliance with the Rule. These procedures must require, among other things, that a designated supervisor review and approve each piece of promotional material prior to first use of the material. This person cannot be the same person who prepared the material, unless that person is the only person qualified to review and approve the material.

Rule 2-29 also effectively supplements members’ CFTC recordkeeping obligations by requiring members to maintain copies of all promotional material (along with a record of the required review and approval of such material, and any materials necessary to support past performance, hypothetical performance, or testimonials included in such materials) for the periods specified in CFTC Rule 1.31 as measured from the date of the material’s last use.

7. Prohibition against Dealing with Non-NFa Members

NFA Bylaw 1101 generally prohibits NFA members from transacting CFTC-regulated business with any person that is required to be registered with the CFTC but is not an NFA member in good standing. Bylaw 1101 thus effectively obligates NFA members to police the CFTC’s and NFA’s registration and membership requirements in their day-to-day business dealings. Importantly for CPOs, the NFA views the acceptance of an investment in a pool as a Bylaw-1101-subject transaction between the pool’s CPO and the pool investor (including any potential CPO of the investor).

Given the strict-liability nature of Bylaw 1101, and the fact that the NFA has referred to it as a “cornerstone” of its regulatory structure, a registered CPO should consider taking several steps to ensure its compliance with the Bylaw, including one or more of the following:

• obtain from each of its pools’ existing and prospective commodity trading advisors, commodity interest brokers

and counterparties, and investors’ CPOs, as applicable, a representation that such persons are either (i) not required to be registered with the CFTC and a member of the NFA in good standing, or (ii) are in full compliance with all such requirements;

• when given a representation that the CPO of an existing or prospective pool investor is not required to be registered as a CPO, perform some level of follow-on diligence to confirm the particular exemption or other basis for the absence of such a registration requirement (often accomplished by including a related questionnaire in the subscription documents for a pool);

• perform additional diligence if Bylaw 1101 compliance questions arise in response to such initial requests, or if the CPO otherwise has reason to believe that a person may be in breach of a CFTC registration or NFA membership obligation, including a review of such person’s status (if any) in the NFA’s online registration/exemption database, Background Affiliation Status Information Center (BASIC) (available at https://www.nfa.futures.org/basicnet/);

• if the CPO of a pool investor relies on a registration exemption that must be reaffirmed annually (such as the CPO registration exemption in CFTC Rule 4.13(a)(3)), confirm annually (via BASIC) whether such exemption has been reaffirmed; and

• maintain a written record of its diligence steps taken to comply with Bylaw 1101.

8. Branch Office Obligations

A branch office is generally any location other than a CFTC registrant’s main business address at which persons associated with the registrant engage in activities requiring registration as an associated person. All branch offices are required to have a branch office manager who is registered as an associated person and has taken and passed FINRA’s futures branch office manager examination (Series 30). A CPO must report the existence of each of its branch offices in its Form 7-R, and must report a person’s status as a branch office manager in that person’s Form 8-R.

CFTC Rule 166.4 and related NFA interpretive positions historically have required that branch offices be an office of the registrant itself, rather than an office of a separately incorporated entity. In the case of certain multinational CPOs, this requirement may raise potentially sensitive tax and non-CFTC regulatory questions, and such CPOs may need to work with their accounting, legal, and other advisors to ensure that all related concerns are properly addressed.

9. Supervisory Obligations

Generally

NFA Compliance Rule 2-9 requires all NFA members to diligently supervise their employees and agents in all aspects of their commodity-interest-related business. As part of that duty, a CPO must establish and implement written supervisory policies

https://www.nfa.futures.org/basicnet/


and procedures (copies of which must be maintained at its main office and each of its branch offices) with respect to various aspects of its operations, including with respect to:

• screening and hiring of employees (including, for example, potentially heightened diligence of prospective employees whose employer has been disciplined by the CFTC, NFA, or other applicable regulators for fraud or similar wrongdoing);

• monitoring employee e-mail and the member’s website (if any);

• handling of investor complaints (including, for example, the designation of a particular employee with primary responsibility for investigating all such complaints);

• training personnel with respect to their duties on behalf of the member and compliance with applicable CFTC and NFA rules (including appropriate qualification of the personnel charged with administering such training); and

• monitoring each branch office’s compliance with the CPO’s policies and procedures, and with applicable CFTC and NFA rules (including annual on-site visits to assess those offices’ compliance).

Ethics Training Program

CPOs’ supervisory policies and procedures also must include written procedures outlining an ongoing ethics training program for each of their associated persons. CPOs generally have flexibility to tailor to their particular circumstances the form and content of their ethics training program, but, per NFA interpretive guidance, all ethics training programs should address at least the following topics:

• an explanation of applicable laws and rules of self-regulatory organizations (including exchanges and execution facilities) to which the CPO may be subject;

• the CPO’s obligation to the public to observe just and equitable principles of trade;

• how to act honestly, fairly, and with due skill, care, and diligence in the best interest of investors and the integrity of the markets;

• how to establish effective supervisory systems and internal controls;

• how to assess the financial circumstances and investment experience of investors;

• procedures for ensuring disclosure of material information to investors; and

• how to avoid, properly disclose, and manage conflicts of interest.

CPOs should ensure that their written ethics training procedures also specify the frequency and format of the training, and who will provide the training. CPOs may furnish ethics training either in-house or through classes sponsored by third-party firms. However, whether the training is furnished in-house or through

a third-party provider, the CPO must ensure that the person providing the training is adequately qualified to do so (including, at a minimum, FINRA Series 3 qualification, three years of industry experience, and an absence of any disciplinary history that could call into question the person’s suitability to provide the training).

Annual Self-Audit

The NFA further requires that each of its members substantiate the adequacy of their supervisory policies and procedures by annually completing a questionnaire-based self-audit process. This process requires a CPO to evaluate its procedures for complying with numerous NFA membership obligations, including separate evaluations for the CPO’s main office and branch offices (as applicable). Upon completing the self-audit, the applicable supervisory person must sign an attestation, affirming his or her belief that the CPO’s procedures adequately address the CPO’s NFA supervisory obligations.

Conclusion

This article has highlighted several CFTC and NFA compliance obligations that newly registered CPOs should ensure they have accounted for in building-out their compliance policies and procedures. Given the substantial nature of these obligations, and the fact that they are by no means exhaustive of a registered CPO’s CFTC and NFA compliance obligations, newly registered CPOs and their compliance personnel should consider allotting a generous amount of time and attention to that task.

This article was written by 2013, Shearman & Sterling LLP and is reprinted with permission from Practical Compliance and Risk Management for the Securities Industry, a professional journal published by Wolters Kluwer Financial Services. The article may not be re-published without permission from Wolters Kluwer Financial Services. Originally published March/April 2013 Wolters Kluwer. ©2013 Wolters Kluwer.

(Endnotes)1 * This publication is intended to serve only as a general discussion of the highlighted issues. It should not be regarded as legal advice.

2 ** [Bios page 21] The authors wish to thank Nhung Pham, an Associate of the Firm, for her contributions to this article.

3 1 The NFA is the self-regulatory organization to which the CFTC has delegated numerous CPO oversight functions. NFA membership is mandatory for all CFTC registrants, including CPOs.


Michael JohngrenTD AmeritradeJersey City, NJ

Amy JonesGuardian Performance Solutions LLCSacramento, CA

LeAnn KemperCetera Financial GroupSt. Cloud, MN

Hannah KimBaker Avenue Asset ManagementSan Francisco, CA

Nicole KroegerRenaissance Regulatory Services, Inc.Boca Raton, FL

Ricky LuthraEast Amherst, NY

George McLambAkre Capital Management, LLCMiddleburg, VA

Nicholas NorvellHNP Capital LLCPittsford, NY

Josh OlsonCalamos Investments LLCNaperville, IL

Hannah SchaeferAEGON USA Securities, Inc.Cedar Rapids, IA

Gail ThiedeCetera Financial SpecialistsSchaumberg, IL

Tim TyczCetera Financial SpecialistsBridgeport, CT

New Members :: New Members :: New Members

Thursday, March 13 – San Francisco, CaliforniaThursday, March 27 – Toronto, Ontario, Canada

Thursday, April 10 – Dallas, TexasWednesday, April 23 – Denver, ColoradoTuesday, April 29 – New York, New York

Thursday, May 8 – Chicago, Illinois--------------------------------------------------------------------------------------

Monday, October 20 – Wed., Oct. 22 – National MeetingGaylord National Resort, National Harbor, Maryland


(Continued on page 31)

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