NFA Requests Comments Regarding CPO/CTA Capital Requirement and Customer Protection Measures (with Lofchie Comment)

The National Futures Association ("NFA") issued a notice soliciting comments on the concept of imposing a capital requirement on CPO and CTA Members as well as other customer protection measures.

According to the Notice, of the 26 Member Responsibility Actions issued by the NFA in the past three years, 92 percent were against CPO and/or CTA members and these measures typically involved misusing customer funds and misstating net asset values or performance information. In light of these actions, the NFA seeks to strengthen the current CPO and CTA regulatory structure to provide greater protection for customer funds.

Currently, there is no requirement for CPO and CTA members to maintain a minimum amount of capital. However, according to the Notice, CPOs and CTAs act as a fiduciary to their pool participants and clients, and should have adequate funds to operate. The NFA is seeking input from members on whether to impose minimum capital requirements on CPOs and CTAs, how the amount of the requirement should be determined, and how often CPOs and CTAs should have to file financial reports with the NFA, among other questions.

Additionally, the NFA is considering and requesting comments on several customer protection measures intended to deal with the risks associated with customer assets held by CPOs. These measures include:

• adopting a rule that requires an independent third party to:
  • review and authorize a CPO's disbursement of any pool funds;
  • prepare or verify a pool's account statements;
  • prepare or verify a pool's performance results;
• requiring CPOs and depositories with whom they maintain custody of pool assets to report account balances to the NFA on a daily basis so that the NFA can identify and compare the information and reconcile any material discrepancies; and
• ceasing to allow inactive CPOs and CTAs to maintain their NFA membership so as to better allocate those regulatory resources.

Comments are due by April 15, 2014.

Lofchie Comment: These are very significant rule changes that would materially affect not only entities that are solely regulated under the CEA, but also many investment advisers whose principal activities are subject to the securities laws and who are also regulated under the CEA because they advise as to futures and swaps. Accordingly, both CFTC registrants and investment advisers should review the rule proposal carefully and consider commenting on both the substance of the proposal and the procedural and regulatory elements. While the NFA Notice does not indicate how much capital that CPOs and CTAs may be required to maintain, we note that the minimum capital requirement for introducing brokers is $45,000 (compared to $5,000 for broker-dealers that act as introducing brokers in the securities markets). Larger firms should also note that the NFA Notice asks whether the level of minimum capital should increase based on a firm's assets under management. The capital proposals are likely to be very expensive to implement, not only because of the cost of maintaining the required capital (which will not in fact be the greater part of the expense), but because of all of the regulatory requirements that go along with compliance with a capital regime. First, the implementation of a capital regime necessarily requires the adoption and implementation of a capital rule that dictates how assets and liabilities are to be valued for purposes of regulatory capital (for example, how should illiquid assets be valued; how should potential tax liabilities be valued?). Second, firms that are subject to a capital regime must comply with that capital regime every day, which means that capital generally must be computed on a daily basis. Third, compliance with a capital regime necessarily implies building a regulatory system around that compliance. One must have detailed records that must be constantly updated; financial records must be audited in compliance with the regulatory scheme; there must be a detailed system of recordkeeping; and so on. The costs of this regime will be borne not only by regulated entities (and indirectly by the customers), but also by the regulators. Building a regulatory apparatus that is capable of conducting audits of thousands of CPOs and CTAs, many of whom are also involved in other activities, is no small operational task. If the capital requirements are to be enforced, the NFA will have to do a very significant build-out at the same time as it conducts inspections of swap dealers and other entities subject to the CEA under Dodd-Frank. For advisory firms that conduct activities in a single entity as both a CTA/CPO and as an investment adviser, the capital regime would inherently apply to their investment advisory activities as well, since it is the legal entity as a whole that is registered. One can certainly question whether the capital requirements would serve a purpose worth the expense of administrating them. It is not really clear why a material risk is presented to investors by CTAs that do not have adequate capital. If a CTA fails, it does not thereby owe its customers money. Further, there is no one who is going to step into the CTA's shoes and manage the client's trading strategy. While the NFA points to advisor malfeasance as a concern, it is not really clear why the NFA believes that a capital requirement will prevent malfeasance (capital requirements are really intended to deal with credit risk, not with fraud). With regard to the proposals designed to address the misuse of customer funds, the NFA proposals would require increased use of external advisors - most importantly, the firm's auditors - to verify account statements and performance information and approve disbursement of pool funds. Firms should consider what impact this would have on their business (e.g., the timing and preparation of marketing materials and account statements) and the associated costs. As a general matter, the NFA Notice makes no mention of relevant requirements applicable to SEC-registered investment advisers under the Advisers Act, especially with respect to custody of client assets. Firms should consider the extent to which compliance with SEC requirements would address the concerns that the NFA Notice is seeking to address. There is a good argument that the NFA should follow the lead of the SEC in line with the substituted compliance regime adopted by the CFTC with respect to SEC and CFTC-registered managers of registered investment companies.The rule proposals raise significant material issues of regulatory procedure and policy. To wit, are rule changes of the type proposed here appropriately initiated by the NFA rather than by the CFTC pursuant to an act of Congress?Clients that are interested in commenting on this proposal may contact Steven Lofchie,Athena Eastood, Dorothy Mehta or their usual Cadwalader contacts.

See: NFA Notice I-14-03.