While it would be fair to say that generally, commodity trading advisors (CTAs) and commodity pool operators (CPOs) have not been the cause of most of the market upheavals over the last few years, it would also be accurate to point out that it really doesn’t matter. Just as they say a rising tide lifts all boats, a rising tide of regulatory oversight puts all managers under a sharper microscope.
With that in mind, National Futures Association held a CPO/CTA regulatory seminar in April to provide guidance to managers, so they understand what is expected of them and can prepare when the regulators come to check them out.
While CTAs and CPOs are not the target of new legislation, many who trade over-the-counter swaps would be affected, says Jon Grady, general counsel of Steben & Company.
CPO participants who engage in swaps would have to be registered as investment advisors, says Grady.
In the past, some of these CPOs may have utilized exemptions to Commodity Futures Trading Commission (CFTC) registration but would probably prefer coming under the CFTC/NFA jurisdiction than the Securities and Exchange Commission. Grady says it is unclear whether or not there would be an exemption from dual registration for those CPOs.
One area that has been ripe for abuse involves what has been termed “pool loans.”
NFA Executive Vice President and COO Dan Driscoll says, “pool loans are a euphemism for stealing money.”
Driscoll pointed out that the term “pool loan” often had come after the fact when several CPOs were caught using pool capital for their own purposes. While there may have been some actual occurrences of funds loaning money from the pool to principals for some valid purpose, that has been the exception. Regina Thoele, NFA senior vice president of compliance, says that some general partners were using pool funds as a piggybank in fraud cases and added that the NFA found no compelling reason for allowing the practice.
“We found that there are very few outstanding loans,” Driscoll says of the practice that is now prohibited.
NFA has adapted rules to make quarterly filings easier to comply to. This has been a problem particularly with fund of funds that have to get all of the reports from the individual programs before they can complete their report. This has made it difficult to report in a timely way and NFA has expanded the time to file and also made it easier to file. This is important as several CTAs have pointed out that particularly the CFTC has made a point of late filings.
Kate Dressel, founder and president of Strategic Compliance Solutions, says, “The purpose of disclosure documents it to protect [your CTA or CPO].”
She says that it is a good idea for 4.7 exempt hedge funds, which are not required to have a disclosure document, to provide some official offering material to potential customers. She warns, however, that just because you are not required to have a disclosure document, you shouldn’t be complacent when making sure all your offering materials are clear and comply with regulations.
This is good advice, as Kristen Harkins, manager of compliance at NFA, says that the most common comment returned by auditors is a manager providing an incomplete business background. It is important that you provide a complete background with correct dates and all material details. “No detail is too small,” Harkins says.
Patricia Cushing, NFA associate director compliance, adds, “The CFTC does review our work and they have asked for more information.”
Cushing points out that although technically a manager is only required to provide a five-year background, if they include returns or other information in their D-Doc from before that five-year period, then additional background must be included.
Many managers struggle with how much information they should include in the document. Dressel says, “If it makes sense, add it because it is relevant. Do not incorporate broad based statements. It would raise questions.”
For instance, many managers who trade a pretty basic strategy will cover themselves by adding a disclaimer that they maintain the right to trade certain cash or over-the- counter instruments if necessary. Often these statements appear to provide cover in case of some unforeseen event, but Dressel says it raises eyebrows, so unless there is a likelihood you will need to access those markets, it is best to leave that out.
Preparing for an audit
The prospect of facing an audit can be a daunting one, but it is part of the business and can be relatively painless if you prepare in advance for it. This is particularly important for smaller firms that don’t have a large staff.
While NFA is required to audit all CTA/CPOs approximately every three years, they have a risk-based audit criteria that may call for more frequent audits. A few things that may cause more frequent audits are: customer complaints, concerns over promotional materials, the size of funds under management, and the degree of leverage used. However, there are some basic areas of focus the NFA is looking for (see “Shining a light”).
Lawrence Block, executive vice president and general counsel of The Kenmar Group, says, “The [NFA self-examination] checklist is your roadmap. If you do that, you are 95% home.”
In most cases, in addition to the self-examination checklist you can find on the NFA website, NFA will send you a checklist of materials they will want to see prior to the audit. They also provide guidance online as to how to prepare for the audit process.
Joseph Picone, NFA compliance manager, says that for most audits they will send a checklist and let you know everything they will be looking for. He says that in some instances, if there have been a large number of customer complaints or some other red flags, they may come in unannounced.
He says the biggest problem that leads to more lengthy audits is failure to produce documents to NFA in a timely fashion.
Thoele says, when possible, NFA will try and have at least one auditor who participated in the last audit NFA performed, so there is someone with an understanding of that manager’s business.
And the opening interview sets the tone. “What is most important is explaining your business. Help the [auditor] understand your business,” Block says, adding that by helping NFA understand everything about your trading business, you can eliminate some avenues of questioning that would not be relevant and would lengthen the process.
Kenmar offers multi-manager products and one of the problems Block has noticed with their feeder funds is not everyone materially involved in the program is listed as a principal. He says anyone with the title of president, CEO, director, or managing member and anyone who has a 10% ownership stake needs to be listed as a principal.
Some new areas of focus NFA is targeting involve valuation and side deals that managers sometimes give selected clients (see “New areas of focus"). While valuation in not a concern for managers who stick to exchange traded futures that are marked to market daily, it is a focus for anyone trading more exotic instruments.
Lennox Compass, NFA compliance field supervisor, says, “Our goal is to make sure your procedures are reasonable.”
He adds that valuation policies need to be disclosed, as do side letters, deals between a CTA/CPO and certain customers that are different from stated policies. This can include different fee structures to preferred redemptions.
Block adds, “Make sure all valuation disclosures are consistent.”
While it is clear that managers are entering a period of greater regulatory scrutiny and one that calls for more disclosure and a higher threshold of transparency, futures industry regulators appear to be working to make compliance easier and more efficient.
There are tools available to help facilitate compliance rather than simply trying to trip up managers or catch wrongdoers, which in the end should create more transparency.