April 15, 2014

National Futures Association
Compliance Division
300 South Riverside Drive, #1800
Chicago, IL 60606

Submitted via Email & Website

re: Request for Comments – CTA/ CPO Capital Requirement and Customer Protection Measures

 Dear Sir or Madame:

We appreciate the opportunity to provide the NFA staff with the comments and recommendations set forth below in response to Notice I-14-03: Request for Comments CTA/CPO Capital Requirements and Customer Protection Measures.

Introduction
Since the collapse of MF Global, we have been stedfastly committed to strengthening investor protections. We are working with various groups on initiatives to shore up customer protections via legislative action, regulatory reform and market innovation. We believe the NFA should focus first on the protection of customer property held by its members and second on the prevention of all manner of fraud through the enforcement of its rules.

It is because of our commitment to enhance customer protections that we do not favor enacting capital requirements on CTA or CPO members of NFA. Enacting capital requirements for CTAs and CPOs would impose a costly compliance burden on emerging managers, stifling competition, innovation and growth in managed futures as an asset class. In exchange for that burden, customers would incur higher trading costs and receive little in the way of an effective deterrent to fraud.

There is no evidence that capital requirements are an effective means to prevent or deter nonfeasance, misfeasance or malfeasance. In fact, capital requirements may actually provide an inducement for members to raise assets through fraud. Capital requirements did not prevent or help detect the loss of customer property from malfeasance at Peregrine Financial Group. Nor did capital requirements stop losses to customer property incurred by Griffin Trading, MF Global or Sentinel Management Group–especially considering the fact that Sentinel was able to opt out of net capital requirements (and change the way they calculated their net capital) by way of a no-action letter from the CFTC.

What ultimately uncovered the fraud at Peregrine, and what may prevent future theft of customer property, is NFA’s new electronic balance confirmation system for FCMs. NFA should focus its efforts on successfully implementing regulatory measures like this one, utilizing technology to enhance customer protections and minimize the cost of compliance. To this end, and as an alternative to a net capital rule for CTAs and CPOs, we recommend that NFA staff and the CTA/CPO Advisory Committee consider the following:

• For CTA Members, a surety or fiduciary bond requirement. A surety bond provides a source of recourse for investors in the case of malfeasance, while not imposing an undue compliance burden on CTAs who pose little theft risk to customer property. This recourse comes from an independent third-party, rather than through the CTA itself, making it much harder for a rogue CTA to impinge on the source of recovery for aggrieved customers.

• For CPO Members, a choice between using an independent third-party administrator for disbursements or electronic confirmation of bank, FCM account balances and transparent assets with monthly reporting of NAV to NFA. The use of a third party administrator and custodian provides a layer of separation and control between the CPO and customer property.  It introduces a measure of checks and balances over the disbursement of that property and would be less costly for firms to implement than net capital rules. Large pools who cannot implement this kind of system could be permitted to opt out of they agree to enhanced reporting requirements, including:  daily confirmation of FCM and bank account balances, daily or periodic confirmation of transparent assets (securities, OTC products, etc) and monthly reporting of NAV to NFA.

We encourage the NFA, its committees and advisors, as well as the industry to consider these proposals in lieu of capital requirements.

Our Analysis of MRAs
In the request for comment, NFA staff noted that the last three years have seen the issuance of 26 Member Responsibility Actions (“MRAs”), 92% of which involved firms which maintained a registration as a CTA or a CPO. We thought it would be instructive to broaden this analysis and look at as much of the history of MRAs as is available.

We analyzed all publicly searchable Member Responsibility Actions (“MRAs”), which includes all MRAs issued from 1998 to 2013 and all those available between 1996 and 1998.  In the data available for this 18 year period, there were a total of 87 cases which resulted in the issuance of an MRA.

MRAs by Year, 1996 – 2013
(Click to view in separate window)

The data show that MRAs are on the rise, with an average of 2.6 MRAs per year in the 10 year period from 1996 to 2006 tripling to about 8 per year in the period from from 2007 to 2013. This increase correlates with the recent rapid increase of CTA/CPO members, as well as the financial crisis.

About 68% of MRAs issued in the analyzed period included firms which maintained a registration as a CTA or CPO, with about 58% coming from firms with only CTA or CPO registrations. As a group, firms which maintained only a CTA registration had the second lowest instance of MRAs by registration (about 9%).

MRAs by Registrant, 1996 – 2013
(Click to view in separate window)

In addition to these MRAs, the NFA issued complaints for seven cases of theft of customer property and six cases of ‘fraud and related matters’ which did not have corresponding MRAs. A spreadsheet of the data we compiled and analyzed is available at this link.

The data shows that registrants in the CTA category do not pose as significant a threat to customer property as CPO registrants. Most of the cases in which MRAs were issued against CTAs were due to the use of misleading or false return information. While those are instances of very serious fraud, they do not constitute the direct threat of theft of customer property. In the few cases where customer property was misappropriated by a CTA registrant, it was through the use of an unregistered pool, direct acceptance of customer funds or through the misappropriation of APS credits. Clearly, custody of customer property is the salient driver of its theft. Dual-registered CTA/CPO members present a higher risk for fraud than CTA-only firms.

Capital Requirements for CTAs

The Question of Fiduciary Duty & Going Concerns
While CTAs are not explicitly required to abide by the standards of a fiduciary, CTAs assume certain fiduciary duties by accepting discretionary trading authority over separately managed accounts. This relationship is controlled by a limited and revocable power of attorney, governed by the agreement between the CTA and customer and granting only the power to affect certain types transactions on a customer’s behalf. Therefore, the fiduciary duty created by this power of attorney is also limited. One question which arises from the NFA’s request for comment is,  does this limited implied fiduciary duty impose a responsibility on the part of the CTA to maintain sufficient assets to remain a going concern?

We contend that the answer is no. The duty owed to customers by the CTA is not derived from the CTA’s assets or financial position, no more than the fiduciary relationship between a doctor and patient rests on that. Instead, the the CTA owes each customer a professional standard of care, to act in the customer’s best interest, carry out its duties prudently and make adequate disclosures to the customer of risks, conflicts of interest, etc.  The CTA custodies no customer assets and customers do not maintain an ownership interest in the CTA’s business. If the CTA were to become insolvent and forced to liquidate its assets to pay creditors, the accounts over which that CTA maintains power of attorney would not be creditors the CTA’s firm. In and of itself, the implied fiduciary duty of the power of attorney is not reason enough to require a level of net capital.

Moreover, imposing a capital requirement is more likely to have the unintended effect of incentivizing practices in direct conflict with a CTA’s implied fiduciary duty. In order to raise assets to comply with capital requirements, CTAs are likely to raise fees or engage in sharing in commissions. These practices begin to raise conflicts of interest between the CTA and his customer which would do greater harm to more customers than the problems which are purportedly prevented by imposing a capital requirement. NFA audits of CTA and CPO members focus heavily on these members’ financial condition and practices, which offers NFA the occasion to oversee the financial stability of CTA members without perverting incentives for these members to remain in compliance.

Even if one thinks there are other reasons for a CTA to be required to maintain a prescribed net capital level as a means to be a ‘going concern,’ we fail to see how a capital requirement promotes that. There are non-financial factors which are more likely to cause a CTA to cease to be a going concern which cannot be effectively addressed through regulation. For example, many emerging managers are exposed to key personnel risk stemming from trading strategy intellectual property being maintained by a few key personnel. It is much more likely that a firm would fail to be a going concern, in the sense that it would be unable to fulfill its contractual obligations to its customers, if such key personnel are incapacitated. Even though NFA has imposed requirements for CTAs to maintain business continuity and disaster recovery plans, these do not address all key personnel risk and neither do capital requirements. Backstopping this is the FCM, which essentially acts as a third party administrator for the customer. Should a CTA be unable to fulfill its duties for whatever reason, the FCM can liquidate a customer’s positions and let me customer resume control of his or her trading account.

Net Capital Rules Would Not Carry More Weight Than Existing Federal Laws
In its request for comment, NFA staff highlight a case in which a CPO member improperly used pool funds for its own purposes as it had insufficient assets to continue operations as a going concern. It is unclear exactly how capital requirements would prevent this. Misappropriating customer property for pool or personal expenses is already against the NFA rules, as well as federal law. A CTA or CPO member who is willing to embezzle or otherwise illegally convert customer property for its own use is unlikely to be deterred by the addition of capital requirements. In fact, compliance with such rules may push such members into committing fraud in order to have the capital to comply with NFA rules.

An Extremely Costly Burden
A capital requirement for CTAs would necessitate a regulatory mechanism to test compliance with that requirement. This would mostly likely mirror the process in place to test FCM and IB compliance with capital requirements. As such, CTA members would be required to submit bi-annual financial statements and annual certified audits of financial statements. The cost to maintain and file these statements and audit is high and burdens small and emerging managers the most. Those who seek to utilize fraud would still be able to, while members who want to be in compliance would see their costs go up–all while customers are no better protected than they are now.

Capital Requirements for CPOs
On the surface, a net capital requirement for CPO members makes sense. After all, these members custody customer property. Customers of CPOs are general creditors in a bankruptcy proceeding of an insolvent commodity pool as they have ownership interest in the pool. As evidenced by NFA data, CPOs are the largest plurality of cases involving fraud or theft of customer property. However, we do not believe that a net capital requirement is in the best interests of protecting customer property or allocating NFA’s regulatory assets.

The CTA/CPO industry relies on managing assets well in excess of the asset management firm’s own assets in order to generate sufficient cash flow to fund the operations and staff required to manage those assets. Generally, if a firm has a large enough balance sheet to conduct all of these operations solely for its own capital, it does not need to undergo the additional costs and burdens of NFA registration, it simply uses a proprietary firm or family office exemption. Moreover, even if pool participants are general creditors of an insolvent pool, they are not general creditors of the CPO itself due to the limited liability protections inherent in pools. Thus, even if a CPO had substantial capital on its own balance sheet, pool participants would not be entitled to said capital in the event of a pool insolvency unless a bankruptcy court were to find fraud to have occurred. Therefore, there is little value add to pool customers should a CPO be forced to meet capital requirements.

The Concern of Going Concerns
As noted above, there have been instances in which CPOs have unlawfully converted pool assets for their own use because they did not otherwise have the resources to continue operations.   Even if net capital rules offer a measure of prevention for this motivation–which is far from proven–a Member that would consider unlawful conversion as an acceptable business practice and is not deterred by prison will not be deterred by net capital rules.

Alternatives to Capital Requirements
NFA should focus its efforts on solutions which offer the greatest measure of prevention.  In our opinion, this would result from adding a layer of controls between customer property and the CPO, with enhanced reporting requirements to help detect potential threats before they become large property losses.

Requirement to Use a Third-Party Administrator and Custodian
The majority of MRAs and fraud cases brought against commodity pool operators have been against small (less than $20M in assets), often single person shops, who simply use the pool bank account as a slush fund. Industry-standard practice for pools in which institutional investors participate is to use a third-party administrator and custodian. Such an arrangement puts two independent third-parties on notice that the funds being held in the pool belong to a regulated commodity pool and require three parties to approve cash disbursements. These independent checks and balances make it virtually impossible for a pool operator to steal funds without at least one of the two independent parties to be negligent or complicit in the fraud.  This greatly reduces the potential for and magnitude of fraud, and raises the prospects of recovery should a well-funded bank or administrator be the aggrieving second party. An ounce of prevention is worth a pound of cure. This method of securing funds is the one of the only proactive approaches being considered at this time. Even with daily balance checks, a CPO without an independent administrator and custodian could simply wire the full bank balance of a pool from his or her cell phone at end of day from a foreign country and never been seen again. Only through proper controls on the transfer of cash can you actually prevent theft.

Daily Electronic Bank, FCM Balance & Other Asset Confirmation with Monthly NAV Reporting
Large pools, which have a high volume of transactions, may find a requirement to use a third-party administrator and custodian operationally difficult. NFA may consider an option where large or complex CPOs have enhanced reporting requirements in the place of a third party administrator and custodian.   This would mean building on the infrastructure NFA has already constructed with the CME to report bank and FCM account balances and expanding that to other asset classes.

Given the broad spectrum of assets in which a pool may invest, such a reporting scheme would be difficult to design and implement. That does not mean that it is impossible.  Even if such a mechanism only captured a portion of the assets held by a CPO, that information would still be useful in the detection of fraud.  It would also be provide useful metrics to inform NFA auditors as to where they should be focusing their attention.

Enhance Reporting by Building a Data Repository for Asset Reporting
Most asset custodians offer some kind of electronic confirmation of the assets they hold in trust.  Ownership of exchange traded securities and derivatives is easy to confirm.  A wide variety of application programming interfaces (“APIs”) and data feeds exist for these asset classes. Many OTC assets are just as easily matched to managers via trade data aggregation services like Triana.  Pools which engage in credit default swaps, repurchase agreements, commercial paper, OTC FX and cash equities can report them via these services.  Less transparent assets like real estate and private placements may have to be self reported and, perhaps as a result, draw more scrutiny from NFA auditors.  NFA will need to build a simple repository for this data and script the mechanism which matches transactions and assets to pools. It is certainly a daunting project, but it is doable and would truly be an innovation worthy of NFA’s motto.

Surety or Fiduciary Bond or Requirements for CTAs
While we believe that net capital requirements to be overly burdensome and provide little protection for customers, surety or fiduciary bonds are a cost effective means to provide customers with financial recourse in the event of malfeasance.  Many states impose surety bond requirements of Registered Investment Advisors as an alternative to net worth or net capital rules.  The exact type of bond, and the scope and amount of coverage required are subjects for study.

Inactive CTA/CPO Members
In Notice I-14-03, NFA also requested comment on the status of hundreds of ‘inactive’ CTA/CPO members that do not engage in commodity trading. In our virtual town hall, the definition of these members was clarified as those who do not engage in trading commodity interests and reply ‘no’ to the question on their annual questionnaire which asks if they are  ‘actively soliciting for customers’. NFA’s concern is that it wastes valuable resources in regulating these members and bears reputational risk from the actions of these members that it might be able to shed by narrowing the qualifications for active membership in the NFA.

We believe the current standards used to delineate active membership are sufficient.  Members pay dues which should adequately fund NFA’s ability to oversee them under the current cost structure, especially if audits of firms with limited activities are conducted in an expedited fashion, as opposed to periods as long as 6 months for many more active Members.  The question of reputational risk is overwrought and largely one mitigated by proper public relations.  It is hard to imagine Members who do not trade or manage money having the capacity to damage NFA’s reputation on the scale of Peregrine or AlphaMetrix.

Conclusion
We think customer protections are paramount to the industry. There is much to be done in the wake of recent FCM failures and cosmic scale ponzi schemes.  We salute the NFA for its proactive approach to protecting customer property and for soliciting input from its membership, industry stakeholders and the investing public.  However, we cannot support regulation that does not meaningfully solve the problems it was meant to fix.  We think that our proposals above offer greater protections to customers at a lower cost to Members. We encourage NFA staff and the CTA/CPO Advisory Committee to add these proposals to the measures they will study to enhance investor protections.

In our preparation to respond to Notice I-14-03, we conducted a virtual town hall for CTA/CPO representatives and received a great deal of correspondence from registered CTAs, CPOs and IBs, as well as industry service providers and the investing public. We would like to thank all of you for your thoughts, comments and participation. We would also like to thank NFA’s General Counsel, Tom Sexton, for participating in our virtual town hall meeting. His service to the membership is greatly appreciated.

Respectfully Submitted,