United States: NFA Issues Internal Controls Guidance For Commodity Pool Operators

Last Updated: December 19 2018
Article by Joshua B. Sterling and Michael M. Philipp

The National Futures Association (NFA) recently proposed an interpretive notice that would require members that are commodity pool operators (CPOs) to adopt and implement internal controls systems designed to deter fraudulent activity (Proposal). The Proposal provides guidance on separation of duties, risk assessments, and recordkeeping. A CPO's internal controls systems would include escalation procedures under which an employee may report to management an attempt by an employee to override the internal controls and inform an employee when a matter should be reported to the CPO's regulators.

While styled as guidance, CPOs should anticipate that NFA will expect them to adopt, implement, and refine policies, procedures, and other mechanisms to address the points that the Proposal raises. Firms should also anticipate that NFA will include a review of CPO internal controls in upcoming examinations, and that NFA will cite firms for any internal controls deficiencies in light of the Proposal.

Background

The NFA has been focused on CPO operations and controls as an area of concern for some time. Over the past few years, it has put forward wide-ranging potential requirements to impose on CPOs and commodity trading advisors (CTAs), while ultimately adopting more narrowly-focused measures designed to improve their monitoring of registered CPOs and CTAs for potential operational concerns.

In 2014, NFA requested comment on a concept release that raised for consideration the imposition of capital requirements and other client and investor protection measures (the Capital Requirement Release).[1] In response to industry comments, NFA later determined not to move forward with proposing capital requirements nor any of the other client and investor protection measures raised in the Capital Requirement Release.

In 2016, NFA adopted a financial ratio reporting requirement that a CPO or CTA must report in Form CPO-PQR or CTA-PR.[2] While much more circumscribed in its scope than the Capital Requirement Release, the financial ratios are intended to identify CPOs and CTAs at which financial pressures have the potential to lead to operational and investor/client protection concerns.

Internal Controls with Escalation Procedures, Separation of Duties, and Risk Assessment

Internal Controls System

Under the Proposal, a CPO's policies and procedures would need to fully explain its internal controls framework and supervisory systems. A CPO would also be required to establish an escalation policy through which employees may report to management an attempt to improperly override the firm's internal controls. Escalation policies should also address when a matter should be reported to a CPO's regulators, such as the NFA or the US Commodity Futures Trading Commission (CFTC). According to the Proposal, a CPO would need to design and implement its internal controls system based on a risk assessment that the CPO would conduct on a periodic basis.

The Proposal also states that management must demonstrate its commitment to integrity and ethical values, and emphasize the importance of establishing and following the internal controls. The Proposal, however, does not detail ways in which management can do so.

NFA recognizes that, given the differences in the size and complexity of the operations of CPO members, including the number of persons employed by the CPO, there must be some degree of flexibility in determining what constitutes an adequate internal controls system. NFA also recognizes that some CPO members are subject to related requirements of other regulators and have designed processes and controls in accordance with those requirements. Compliance with those requirements by a CPO member, and in some instances the CPO's pool and/or service provider, may satisfy a CPO member's supervisory obligations under Compliance Rule 2-9 to have an adequate system of internal controls.

Separation of Duties

The Proposal would require a CPO's internal controls system to provide for the segregation of duties such that no single employee is in a position to carry out and conceal errors or fraud or have control over any two phases of a covered transaction or operation.

NFA advised that those employees who perform the day-to-day functions of the CPO's business (such as the handling of pool funds, trade execution activities, financial records, and risk management) should be different persons than those who supervise those functions. Further, principals of a CPO or another appropriate supervisory person should review the work of supervisors who also handle day-to-day functions.

NFA highlighted three standards a CPO should require "whenever possible" to ensure proper segregation of duties:

  • Duties are assigned to different employees in a manner, or there are appropriate automated controls, that ensures there is a regular cross-checking of the work performed in material areas
  • Operational functions relating to custody of pool assets are segregated from financial reporting functions such as recordkeeping/accounting for the assets
  • In the pool funds area (e.g., subscriptions, transfers, and redemptions), no one person should be responsible for initiating a transaction, approving the transaction, recording the transaction, and reconciling the account to third-party documentation and information

Risk Assessment

To develop and implement its internal controls system, a CPO would be required under the Proposal to conduct a risk assessment designed to identify the CPO's most critical risks. A CPO must perform the risk assessment periodically and upon a change to the CPO's business or operations.

NFA identified three risk areas that are generally applicable to all CPO businesses and, thus, should be addressed by all CPOs' internal controls systems. The areas identified by NFA include the following:

  • Pool Subscriptions, Redemptions, and Transfers
    • Verification that pool investments are held in properly titled accounts and not comingled with the assets of any other person
    • Reconciliation on a periodic basis of transactions between the pool's general ledger, banks, and other third-party depositories
    • Authorization of redemptions, including verification that the request is made by a participant, adequate funds are available, proper calculation of NAV and amount of funds to be released, and timely payment is made

  • Risk Management and Investment and Valuation of Pool Funds

This area of the risk assessment should focus on the investment activity carried out by a CPO and the pools it operates. Specific activities that should be addressed include the following:

  • Approval of investments to ensure that each type of investment is authorized by the pool's strategy
  • Verification of investment valuation and compliance with the CPO's valuation policies
  • Ongoing due diligence of counterparties
  • Ongoing monitoring of the risks associated with investments held at third parties (including market and credit risks)
  • Ongoing monitoring of pool liquidity to ensure that the pool will be able to meet its financial obligations such as redemption requests and margin calls
  • Use of Administrators

A CPO should have controls to ensure that the CPO performs adequate due diligence of third-party administrators, including initial and ongoing due diligence. A CPO should also request and obtain evidence of testing of the administrator's controls by an internal audit department or independent specialist. A CPO who fails to adequately supervise its administrators and allows client funds to be put at risk may be subject to an enforcement action by the CFTC.[3]

Record Keeping

Under the Proposal, each CPO must maintain records that support the implementation and effectiveness of its internal controls system.

Potential Next Steps in Light of the Proposal

Assuming that the Proposal becomes effective after the 10-day notice period, CPOs should pay attention for future communications from NFA regarding implementation and effectiveness of the Proposal. From there, the specific steps firms may wish to consider taking will likely vary based on their specific facts and circumstances and any existing internal controls systems that have been implemented. Firms considering registration as CPOs should also consider the resource and time commitments necessary to operate in accordance with the Proposal, given their intended scope of operations once so registered.

Given the foregoing, firms evaluating the Proposal may wish to take into consideration the following points and potential next steps:

  • Review existing internal controls frameworks and look for any "gaps" compared to the Proposal. Existing controls may or may not cover all the points NFA has raised. Even if they do, existing controls may need to be fine-tuned to address specific CFTC and NFA requirements applicable to a CPO and its operation of commodity pools
  • Fill identified gaps. New controls can be adopted, or existing controls tailored, in light of the results of any review that a firm undertakes. As noted above, gaps could exist where existing procedures are not tied to specific CFTC and NFA requirements
  • Address segregation of personnel. Review internal controls policies to determine whether they adequately address segregation of duties as described in the Proposal and take steps to separate duties as needed
  • Train employees on controls processes relevant to their roles within the organization. Use training and other informational processes to foster an understanding of escalation procedures for reporting an attempt to circumvent the internal controls system
  • Update recordkeeping requirements, as needed or advisable, to ensure that internal controls measures contemplated by the Proposal are appropriately documented

Fundamentally, a firm's culture and "tone at the top" drive its commitment to doing the right thing and addressing legal and regulatory requirements that govern its conduct. Internal controls are, in a sense, proof that the culture and tone are carried out through an organization's DNA. Any efforts to review and implement the Proposal are more likely to be fruitful to an organization if they aim toward a culture of compliance. That is, policies and procedures should not be promulgated, and controls should not be implemented, merely to "check the box" against what NFA has published. Rather, any review and revisions undertaken in response to the Proposal would be best directed toward the important goal of having a strong operational road map for carrying out a firm's compliance with legal and regulatory requirements.

Footnotes

1 See NFA Notice I—14-03.

2 See "Collection of CPO/CTA Financial Information – NFA Compliance Rule 2-46" and NFA Interpretive Notice NFA Compliance Rule 2-46: Reporting Financial Information of NFA Forms PQR and PR;" see also "NFA Proposal Would Require CFTC-Registered Asset Managers to Report on Financial Condition.

3 See In the Matter of Tillage Commodities, LLC, CFTC Docket No. 17-27 (Sept. 28, 2017) (holding a CPO accountable for failure to supervise its fund administrator's operation of the commodity pool's bank account containing participant funds and failure to ensure that its compliance program comported with its duty to diligently supervise all employees, partners, officers, and agents in all commodities futures business).

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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