United States: NFA Proposal Would Require CFTC-Registered Asset Managers To Report On Financial Condition

Last Updated: September 19 2016
Article by Joshua B. Sterling, Michael M. Philipp and Sarah V. Riddell

The National Futures Association's (NFA's) latest proposal would require registered commodity pool operators and commodity trading advisors to provide new information about their financial condition in quarterly reports to NFA; while the information is limited in scope, it could trigger enhanced scrutiny of a firm's financial condition by regulators and serve as a basis for examination.

NFA's New Customer Protection Efforts

NFA recently proposed enhanced financial reporting obligations (2016 Proposal) for commodity pool operators and commodity trading advisors that are registered with the US Commodity Futures Trading Commission (CFTC) and are members of NFA (CPO/CTAs).1 The 2016 Proposal appears to follow along the same vein as NFA's concept release on customer protection issues in which NFA requested comment on the imposition of minimum capital requirements on CPO/CTAs, among other regulatory initiatives (Concept Release).2 While the 2016 Proposal is less burdensome than the Concept Release, it is significant in that NFA would have a more granular view of CPO/CTAs' finances.

NFA would use this new financial information (consisting of asset/liability and revenue/expense ratios) to determine a CPO/CTA's financial risk profile and to identify CPO/CTAs that may be facing financial difficulties. Although NFA would not mandate that a CPO/CTA satisfy minimum ratio percentages, NFA hopes to identify trends indicating when a CPO/CTA may face financial difficulties that could "impair its ability to act in the best interests of its customers" by incorporating this information in NFA's oversight program.

Background

While the 2016 Proposal does not mention the Concept Release, it would appear to take its inspiration from the same underlying concern—namely, that a CPO/CTA could experience an adverse change in its finances that could put its business and client assets at risk. This concern was certainly a motivating force for the Concept Release, as the NFA was concerned to discover that a CPO/CTA member firm had suffered financial hardship and converted client assets to cover its business operations.3 In particular, the Concept Release suggested additional potential requirements for CPO/CTAs, which notably included

  • a minimum capital requirement;
  • review and authorization by an independent third party of a CPO's disbursement of pool funds;
  • preparation or verification of a CPO's account statements and performance results by an independent third party;
  • daily reports of account balances filed by depositories holding pool assets and the CPO itself; and
  • automatic withdrawal of NFA membership for inactive CPO/CTAs.

The Concept Release was not well received by the managed funds industry.4 Since that time, NFA had not taken further public action on the Concept Release to address its underlying concern about the financial health of CPO/CTAs and the related potential risks to client assets.

Proposed Reporting of CPO/CTAs' Financial Condition

Overview

The 2016 Proposal would amend NFA Compliance Rule 2-46 to require a CPO that files CFTC Form PQR with NFA in lieu of NFA Form PQR to file "any additional information in a form and manner prescribed by NFA", thereby enabling NFA to capture the financial ratios it will obtain from NFA Form PQR.

NFA also has proposed an interpretive notice that describes the additional information that NFA wishes to obtain from CPO/CTAs in NFA Forms PQR and PR. NFA proposes to require a CPO/CTA to provide two ratios related to the firm's financial health using generally accepted accounting principles or other internationally recognized accounting standards. NFA would mandate the use of the accrual method of accounting. Thus, a CPO/CTA must record revenue when it is earned instead of when it is received in cash, and must record an expense when it is incurred instead of when it is paid. The financial ratios must be rounded to the nearest two decimal places. For CPO/CTAs whose fiscal years do not coincide with the Forms PQR and PR reporting quarters, NFA will permit such CPO/CTAs to report the financial ratios as of their most recently ended fiscal quarter.

In addition to submitting the financial ratios to NFA, a CPO/CTA must be able to demonstrate to NFA how it calculated the financial ratios. Therefore, a CPO/CTA must maintain records supporting the calculation of the financial ratios, including relevant financial records of its holding company if it elects to report at the parent or holding company level. In accordance with NFA Compliance Rule 2-10, a CPO/CTA would be required to provide these records to NFA during an examination or upon request. NFA may share the information it gathers from quarterly financial reporting with other regulatory agencies, such as the CFTC and the US Securities and Exchange Commission (SEC). It is important to note that Forms PQR and PR are considered nonpublic records5 that a third party may request pursuant to the Freedom of Information Act (FOIA). Thus, CPO/CTAs should submit FOIA requests for confidential treatment to the CFTC and NFA when they file their quarterly reports with NFA.

Current Assets/Current Liabilities (CA/CL) Ratio

The CA/CL ratio measures a CPO/CTA's liquidity based on financial information as of the end of the reporting quarter.

  • NFA defines a current asset to include cash or any asset that can be readily converted to cash within one year. A current asset obviously includes cash, as well as accounts receivable, marketable securities, short-term investments, and the general partner's investment in its fund.
  • A current liability includes any obligation that is reasonably expected to be paid within one year, such as accounts payable, accrued expenses, payroll liabilities, income tax liabilities, and interest payable. Long-term financial obligations that are not due within the present accounting year should not be included as a current liability.

Total Revenue/Total Expenses (TR/TE) Ratio

The TR/TE ratio measures a CPO/CTA's operating margin, reflecting total revenue earned and total expenses incurred during the prior 12 months (as opposed to being earned or incurred during the reporting period).

  • Total revenue includes gross income that a CPO/CTA earns from normal business activities (such as management or incentive fees) before any expenses have been deducted.
  • Total expenses include costs that a CPO/CTA incurs in its effort to generate revenue (i.e., the cost of doing business), such as wages and salaries, rent, utilities, depreciation, and bad debts.

NFA's apparent motivation for this proposal is understandable given its role and responsibilities. While the 2016 Proposal imposes far fewer burdens on CPO/CTAs than the Concept Release's measures, it remains unclear whether new financial reporting will enable a regulator to detect fraud or other misconduct, which could be better addressed through enforcement of the existing legal and regulatory framework. NFA does not appear to be willing to forego a customer protection measure, and it is encouraging that NFA has struck a better balance between regulatory goals and industry costs than the alternatives in the Concept Release.

Relationship to Reporting Developments of Other Regulators

NFA is not alone in requiring its members to provide more information to the regulator. Starting on October 1, 2017, an asset manager regulated by the SEC will be subject to enhanced reporting requirements with respect to separately managed accounts, similar to that which is already required for private funds.6 Among other requirements, an asset manager will be subject to additional reporting about its use of derivatives in relation to separately managed accounts. Under the final rules, an asset manager also must identify any custodians that account for at least 10% or more of an asset manager's regulatory assets under management attributable to separately managed accounts, and the amount of separately managed account assets held by each such custodian.

Although not finalized, the SEC's September 2015 proposal governing liquidity risk management requirements7 applicable to mutual funds (described in our September 2015 LawFlash) illustrates the types of new financial data that the SEC seeks to obtain to monitor fund activities. Among other requirements, a mutual fund subject to the proposal would need to

  • establish a liquidity risk management program;
  • determine a three-day liquid asset minimum (i.e., a minimum percentage of net assets that must be convertible to cash within three days) based on its investment strategy, cash flow projections, use of borrowings and derivatives for investment purposes, and other factors, and have it approved by the fund's board of directors; and
  • adhere to reporting requirements.

For example, a fund would be required to disclose the three-day liquid asset minimum, liquidity classification of fund assets, and liquidity risk management practices on various SEC forms.

Next Steps

NFA's 2016 Proposal can be made effective in six months, unless the CFTC approves the rule at an earlier time or institutes disapproval proceedings. CPO/CTAs should monitor CFTC actions regarding the 2016 Proposal and be prepared to provide the financial ratios in quarterly reports as soon as June 2017.

Footnotes

1 CFTC Rule Filing Pursuant to Section 17(j) of the Commodity Exchange Act, letter from Thomas Sexton, Senior Vice President and General Counsel, NFA, to Christopher Kirkpatrick, Secretary, CFTC (Sept. 6, 2016).

2 NFA Notice I-14-03, Request for Comments – CPO/CTA Capital Requirement and Customer Protection Measures (Jan. 23, 2014).

3 In the Matter of AlphaMetrix LLC, NFA Case No. 13-MRA-007 (Oct. 21, 2013); see also CFTC v. AlphaMetrix, LLC, et al., No. 1:13-cv-7896 (N.D. Ill., Dec. 16, 2014) (consent order for permanent injunction and other equitable relief and penalties).

4 See, e.g., letter from Stuart J. Kaswell, Executive Vice President & Managing Director, General Counsel, Managed Funds Association, to Mary McHenry, Associate Director, Compliance, and Julia Wood, Attorney, National Futures Association (Apr. 15, 2014); and letter from Matthew J. Nevins, Managing Director and Associate General Counsel, Asset Management Group of the Securities Industry and Financial Markets Association, to Daniel A. Driscoll, Executive Vice President, Chief Operating Officer, and Thomas W. Sexton, III, Senior Vice President, General Counsel and Secretary, National Futures Association (Apr. 15, 2014).

5 See, e.g., 17 C.F.R. §§ 4.27, 145.0.

6 Form ADV and Investment Advisers Act Rules, SEC Release No. IA-4509 (Aug. 25, 2016).

7 Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release, SEC Release No. 33-9922 (Sept. 22, 2015).

This article is provided as a general informational service and it should not be construed as imparting legal advice on any specific matter.

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