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News September 3, 2012 Issue

Everything You Need to Know About CFTC/NFA Registration

The fast plunge to the December 31 registration deadline is on, and if your firm can no longer avoid registration as a commodity pool operator (CPO) or commodity trading adviser (CTA), you’ve got your work cut out for you.

On August 28, ACA Compliance Group principal consultants Scott Brindley and Rick Geissman hosted an hour-long webinar on this important topic facing many advisers, covering the ins and outs of registration with the CFTC and National Futures Association (NFA). They also answered a series of questions from advisers facing the registration process.

Brindley (SB) and Geissman (RG), both former NFA staffers, are industry veterans with experience ranging from consulting positions in the regulatory practices of big 4 accounting firms to in-house compliance positions with firms in the industry.

They launched into the presentation by describing the contours of the new regulatory landscape.

Does my firm have to register, and what is involved in the registration process?

SB: These are the two main questions. The recent changes to Part 4 of the Commodity Exchange Act (CEA) rescinded the commonly used exemption from CPO registration in Rule 4.13(a)(4). Now only the Rule 4.13(a)(3) exemption for de minimis transactions remains.

How can a firm remain exempt?

RG: The Rule 4.13(a)(3) de minimis test is still available. Each pool must meet one of the following tests:

  • The aggregate initial margin/premium does not exceed five percent of the liquidation value of the pool’s portfolio; or
  • The aggregate net notional value of commodity interest positions does not exceed 100 percent of the liquidation value of the pool’s portfolio.

Keep in mind that "commodity interests" now include swaps.

The definition of a swap is detailed and comprehensive and was recently published in a release that is about 600 pages long.

Generally speaking, security-based swaps are those based on securities, the yield of a debt security, a loan, or a narrow-based security index. Credit default swaps are also security-based swaps.

It is important to note that regarding swaps, hedging activity is NOT excluded from the tests. This is very important and there is some confusion about that.

Also, certain insurance products, consumer and commercial agreements, and loan participations are not swaps.

SB: Funds of funds also can have protections from registration under the de minimis exemption. Appendix A to Part 4 of the regulations offers guidance in this regard to funds of funds.

The CFTC withdrew Appendix A in February, but is allowing CPOs of funds of funds to continue to rely on that guidance until the CFTC adopts revised guidance. The revised guidance is expected to be called "Appendix D."

Appendix A lays out six different scenarios, and you can rely on the de minimis exclusion if you fall within any one of them.

For example, in Scenario 5 an investor fund for a CPO allocates no more than 50 percent of the fund’s assets to investee funds, i.e. underlying managers. The investing fund doesn’t have to regard the amount of commodity interests held by investee pools, it just tracks the allocation of fund assets to ensure only 50 percent are with underlying managers.

Scenario 6 permits a 50 percent allocation of fund assets to underlying funds plus direct investment in commodity interests. You must treat funds directly traded in commodity interests as a separate pool.

If you’re a fund of funds manager, talk to your consultants and outside counsel to determine if an Appendix A scenario works for you.

What specific relief is provided in Regulation 4.7? What are the conditions?

SB: Registered CPOs and CTAs may claim relief under Rule 4.7 from certain reporting and recordkeeping requirements when the CPO’s pool participants or the CTA’s clients are "qualified eligible persons" (QEP).

The QEP definition is rather long. US natural persons are accredited investors with certain portfolio requirements as laid out in the regulations.

Rule 4.7 is also known as "regulation lite." The greatest benefit for CPOs, in my opinion, is that no CPO disclosure document is required.

Also, capital statements may be distributed quarterly instead of monthly.

If you can’t rely on Rule 4.7 for any particular fund, you need a balance sheet and an income statement.

The benefits under the rule for CTAs are very similar. No disclosure document is required, provided that the advisory agreement contains the disclosures required by Rule 4.7(c)(1), and the client consents to his account being exempt under the rule.

Identifying CPOs and CTAs.

RG: It is a common misconception that you identify one entity and it must register. Often, a number of legal entities will be required to register.

A CPO is "any person engaged in the business that is of the nature of an investment trust, syndicate or similar form of enterprise, and who, in connection therewith, solicits, accepts or receives from others funds . . . for the purpose of trading in commodity interests…including any…swap."

The CPO is often the managing member or general partner (GP) of a limited partnership (LP). Many funds are structured as LPs, and in many circumstances, the GP is the presumptive CPO.

Each commodity pool has one CPO and one CTA, although they can be the same entity. A single pool may also have multiple CPOs and CTAs.

If you have ten pools with ten separate legal entity GPs, you potentially have ten CPO registrants. Delegation is a tool available to enterprises with multiple entities requiring registration. An entity that is a CPO would delegate responsibilities to another registered CPO. Outside counsel can help determine whether delegation available to you.

A CTA is "any person who…for compensation or profit engages in the business of advising others…as to the value or the advisability of trading in any contract of sale of a commodity for future delivery…or swap."

In a fund with no separate adviser, the GP or managing member is both the CPO and the CTA. In a corporate structure, the adviser is usually both the CPO and the CTA. In a separate account, the adviser is the CTA, and there is no CPO.

CTA registration exemptions.

Rule 4.14(a)(10), one of the more common CTA registration exemptions available, allows a CTA to avoid registration where it has provided commodity interest trading advice to no more than 15 clients during the prior 12 months and it does not hold itself out as a CTA.

Rule 4.14(a)(8) is available to advisers whose advice is solely limited to pools that are exempt under 4.13(a)(3), 4.13(a)(4) and 4.5.

Rule 4.14(a)(4) is available to advisers that are registered as CPOs and whose advice is solely limited to pools for which they are so registered.

Often there will be a separate legal entity delegated as investment manager. This is the entity most will consider for CTA registration or exemption. To the extent you have multiple CPOs with differing legal entities, it becomes a more complex assessment. Use your legal counsel in making these determinations.

Identifying principals and associated persons.

Who is a principal?

SB: Principals are defined by their title or position at the firm, financial or ownership interest in the registrant, or controlling influence over the registrant’s business activities.

Principals will be GPs, managing members, presidents and other corporate level executives. Also, the heads of business units that are subject to CFTC regulation will be principals.

Both individuals and entities owning ten percent or more of the registrant’s stock, or that have contributed ten percent or more of the registrant’s capital will be considered principals.

"Controlling interest" over a registrant’s business activities is more or less a catchall, and can provide for ambiguity or confusion when you’re dealing with whether an individual or entity has controlling influence.

This is determined on a case-by-case basis and you should have a discussion with counsel or your consultant.

Who is an associated person?

SB: Associated persons are those who solicit business – orders, customers, or customer funds – on behalf of any NFA member firm.

Anyone who supervises an associated person is also an associated person.

It is important to look up the supervisory chain of command to identify additional associated persons. The NFA has issued a notice for guidance on the supervisory chain of command.

Principals apply to the NFA and pay a fee. Associated persons do the same, but must also meet proficiency requirements – the Series 3 exam.

The Series 3 exam.

The Series 3 examination consists of 120 true/false and multiple choice questions – 85 questions on the subject of market knowledge, and 35 questions on the rules and regulations.

Individuals taking the exam must be knowledgeable in the theory and terminology of the futures industry. They must understand futures margins, options premiums, settlement, delivery and assignment. The Series 3 will also explore knowledge of various types of orders, such as market orders, stop orders, limit orders, ‘good till cancelled’ orders and ‘fill or kill’ orders.

Additionally, a candidate must understand basic hedging and speculation in the industry, as well as the rules and regulations. Candidates sitting for the Series 3 must understand the general rules for all NFA members and CFTC registrants – the ‘know your customer’ rules, supervision rules, and other rules for all members.

Individuals must know specific CPO and CTA regulations, and also some rules specific to the brokerage side. This would include Futures Commission Merchants (FCMs) and introducing brokers.

Many advisers currently faced with CFTC registration are operating in the private fund space, and there will be topics on the exam that don’t relate to your business operations. It is very important to prepare for the exam.

Bottleneck Number One: The Series 3 requires some preparation.

SB: Some of the individuals who need to take this exam are your marketing folks and your investor relations folks, they’re not necessarily the portfolio managers and the traders. Some of these folks may not be proficient in areas regarding trading theory terminology.

This is definitely a potential bottleneck in the process. In fact, if I had to pick one bottleneck, this would be it, the Series 3 exam.

If a candidate fails the exam, they need to sit out 30 days before they can take the exam again. If the applicant fails a second time, he or she must sit out another 30 days. If an applicant fails the exam a third time and more, they must wait 180 days after each attempt before becoming eligible to try again.

There are two testing alternatives to meeting this proficiency requirement – the Series 31 and Series 32 exams.

Series 31 is available to individuals registered with FINRA as registered representatives and sponsored by broker-dealers, as well as NFA member firms.

Series 32 is available to individuals in the UK and Canada.

The important thing to note is that the results of these exams need to be sent over to the NFA in order for processing to take place.

Also, waivers of the exam requirement are available under NFA Registration Rule 4.02. You have to be careful to assess whether waivers can be used. The NFA will assess the applicability of waivers on a case-by-case basis.

NFA Rule 4.02 uses terms that are subject to interpretation and you should certainly get counsel involved if you’re going to seek this waiver. What you believe may qualify you under the rule may not match the NFA’s position.

Don’t rely on the face of that rule and then be stuck at the latter end of this year with individuals who need to take the exam and are unprepared.

Bottleneck Number Two: Fingerprinting is critical – send two original sets.

SB: Although only associated persons must meet the proficiency requirements, both principals and associated persons must be fingerprinted. You may not be used to this, but it is a part of the process, and digital images of the fingerprints will be sent to the FBI for background checks.

This can be a second bottleneck, another important issue that could hold up registration.


The FBI will reject any fingerprints that they can’t read. Therefore, you need to engage a person experienced in rolling these fingerprints, and you should submit more than one set of fingerprints to the NFA. The NFA even suggests that themselves.

You don’t want to be caught in December submitting fingerprint cards that the FBI can’t read and therefore all of your principals can’t get registered in time. You would have an issue, so it’s an important thing to keep your eye on.

Another important point to note – the NFA will only accept an FBI "applicant" card, not a fingerprint card that is used for criminal activity. There is a difference. The NFA will provide cards if you request them.

NFA’s Online Registration System.

RG: Now that you’ve assessed your enterprise and figured out that you have CPOs or CTAs that require registration and have determined the individuals at your firm who are principals and associated persons, what is the process to get them registered with NFA?

The answer is the NFA’s Online Registration System (ORS).

The ORS process will be managed by an individual within your firm called the Security Manager (SM). The SM will enroll the firm and gain access to ORS.

For those funds that have been exempt under Rule 4.13(a)(4), the CPO has already made a claim for exemption and an NFA identification number has been generated. This non-registrant NFA identification number should be used to register the firm going forward.

The ORS is the platform which the SM will use to submit the CPO and CTA firm applications using Form 7R, and the individual principal and associated person applications using Form 8R on the system.

Once submitted, an applicant has 90 days to meet all requirements.

RG: I’m often asked about the process for individuals and how the applications are verified. The SM will input information about individuals and each individual will go in independently (using a temporary password) and verify the accuracy of the submission.

The platform will allow the SM to track the progress on fingerprints for all principals and associated persons, ensure the submission of results for all professional examinations, and track the payment of application fees and all NFA membership dues.

Your consultant can handle the SM function throughout the entire process.

File now and still get delayed effectiveness.

The registration deadline is December 31 for those funds whose exemptions are extinguishing.

For funds formerly exempt under Rule 4.13(a)(4), pre-registration is not only an option, it is really the default. The NFA will recognize these applicants and automatically make the date of their registration January 1, 2013. Funds wanting to register before January 1, 2013 must notify NFA that they want to register early.

On December 31, all exemptions will be withdrawn and the online registration system will look for effective registrations or another effective exemption.

The CFTC and NFA have also indicated that pre-filing of exemptions is an option. For example, a currently exempt firm that will move to Rule 4.7 beginning January 1, can pre-file such that both registration and Rule 4.7 status will become effective on January 1.

Ongoing regulatory compliance obligations.

RB: Once you register and become an NFA member, there are a number of ongoing compliance responsibilities.

For example, the firm must annually complete a self-examination questionnaire, really a self-audit. The firm must also conduct a review of firm operations to ensure that the firm is compliant with NFA rules and CFTC regulations. Registrants must conduct testing of business continuity and disaster recovery plans, review of electronic communications including email, and ethics training for associated persons, among others.

SB: There are front-end issues you need to discuss with counsel, but consultants can help you with the ongoing obligations.

Things that can hold up the processing of your application(s).

SB: The NFA on their web site talks about the process taking approximately six weeks, but they are not required to process your application in any specific time frame.

You want to get on this sooner rather than later, especially in this environment. We suggest you allow two to three months to get this done. You don’t want to be entering the fourth quarter and just beginning the process. Within the next 30 days, firms needing to act should be well on their way.

What are some of the things that can hold up the process? It can depend on how complex your firm and your operations are.

  • If you’re a foreign entity you certainly need to allow for more time. The background check will include an Interpol check and those take longer. Also for the fitness info, the criminal checks, etc., in general the process can take longer because these are all things the NFA could need addtional time to look into. Again, the NFA has no specific time frame to act, so you need to keep that in mind.
  • Avoid misconceptions about your ability to rely on the Rule 4.13(a)(3) de minimis exemption if you’re a fund of funds manager. Don’t assume that’s the case. You need to get out to counsel, say here’s my situation, can I use this exemption? If you can’t, you’ve got to get moving on registration.
  • Along those lines, be careful with the waiver requests as well. It is human nature to get excited about any kind of waiver in that respect. But certainly have that conversation with counsel, as to whether you truly meet the purpose of that waiver and whether you are meet the definition of "primarily engaged in securities."
    That’s an interpretation you don’t want to leave until the end of the year, you could find yourself in a bind.
  • As mentioned above – if a candidate fails the Series 3 exam, waiting periods will apply before they can take the test again. The first and second failures each impose 30 day waiting periods. If an applicant fails the exam a third time and more, they must wait 180 days after each attempt before becoming eligible to try again.

All these things are very important, and it is already September. For those of you who think you might have to register, we can’t emphasize enough that this needs to be on the top of your plate.

Questions From the Audience.

Q. Does a third party institution that provided seed capital and owns over ten percent of the CPO need to register as a principal? Since we don’t control them, what if they don’t cooperate?

RG: Yes, direct owners of ten percent or more of a pool that are entities do need to be listed as a principal. If they don’t cooperate, inform them that if they do not register and comply with all the rules of the NFA, the CPO will be subject to regulatory action, including fines and in extreme cases, expulsion from the industry.

That is something you’re going to have to work out with the institution.

Q. Even if the firm is requesting a Rule 4.13(a)(3) exemption, or is registering under Rule 4.7, does the Series 3 apply to our principals?

SB: If you’re going to use the Rule 4.13(a)(3) exemption from registration, you’re exempt from all requirements, other than that you must reaffirm that exemption on an annual basis.

If you’re a Rule 4.7 firm, your associated persons must take the Series 3 proficiency exam, not your principals, but both your principals and associated persons must be fingerprinted. Rule 4.7 relieves CPOs and CTAs of the disclosure document requirement, and relieves CPOs of certain reporting obligations. It does not relieve firms of any Series 3 requirements for their associated persons.

RG: Yes, the Series 3 is only required for associated persons. Principals do not need to take the Series 3 proficiency exam.

Q. If the director of investor relations reports to the CFO, will the director, the CFO and all investor relations staff need to complete the Series 3?

RG: Again, the Series 3 is only required for associated persons. The investor relations role is one of those areas often brought up with regard to principal and associated person registration, however.

What exactly constitutes an associated person? It is someone who solicits others for participation in a commodity pool or commodity account.

Because investor relations personnel are client facing, there may be some gray area in their role and whether their activity may qualify as associated person activity.

We can assess that with you with more detail, but generally investor relations personnel, if they really are performing more of a customer service function and are not really involved in solicitation and marketing, should not need to register as associated persons.

Q. The jurisdiction of the NFA and CFTC is limited to certain U.S. markets. How does this impact asset managers who trade commodities only on foreign markets?

SB: There is a three-pronged test when determining whether CFTC jurisdiction is relevant. You must look at where the firm is located, where the customer (investor) is located, and where the exchange is located.

A U.S. firm with a U.S. investor trading on a foreign exchange DOES need to register.

A U.S. firm with a foreign investor trading on a foreign exchange DOES NOT need to register.

You need to consider the locations of the firm, the investor, and the exchange, all three.

Q. Does investment in a single commodities futures contract by an adviser to a separate account require the adviser to register as CTA? Is there any de minimis commodity futures trading exception for CTAs?

RG: The adviser in this situation probably would be exempt. Section 4(m)(1) of the CEA and Rule 4.14(a)(10) would probably apply. Those relate to a firm providing advice to no more than 15 persons in the prior 12 months and that did not hold out as a CTA.

Q. If a firm registers by December 31, does that mean that associated persons have 90 days afterward to submit fingerprint cards and take the Series 3, or must it all be completed by January 1, 2013?

SB: The answer is the latter, it needs to be all in. In fact, not only does it need to be all in, but all in and approved. Again, the NFA does not give a time frame on how long that will take, so you have to err on the side of caution and begin this process early.

Q. If principals are soliciting investors, do they have to be registered as associated persons as well?

RG: Yes. If they are soliciting, they are engaged in activity that meets the definition of associated person. Just because they’re a principal does not mean that they are not also an associated person.

In fact, one of the requirements to get a firm registered with the NFA is that it must have at least one person in the firm who is both a principal and an associated person.

Q. Will the Series 3 be required for the sales team at a fund of funds firm?

SB: This is a tough one, because the answer depends on whether they’re reaching out to investors directly or not. But more importantly, every NFA member firm needs to have at least one individual who’s an associated person.

The associated person definition does not fit nicely into all hedge fund structures. Nevertheless, that‘s what we have to work with. We have to apply the rule to whatever operations are going on, even in a fund of funds structure.

It is very important to focus on the requirement that at least one individual at the firm needs to be both a principal and an associated person. Just because it is a fund of funds structure doesn’t change the rule. You’ve got to look on a case-by-case basis at which people are engaged in which activities.

Q. I understand that the GP of a limited partnership is the CPO, but what about the investment manager?

RG: This question hits right at the point of assessment of all the entities in an enterprise. The adviser, if they are a separate legal entity – which I assume is what the question is getting at – will most likely have to register as a CTA. It may be exempt under some of the exemptions we’ve discussed, but certainly that assessment needs to take place. It may very well be the case that the separate legal entity as investment manager does require separate CTA registration.

Q. Do third party marketers need to register as associated persons of a CPO?

SB: A great question. It brings up a topic that most SEC registrants may not be familiar with – NFA Bylaw 1101. Rick talked about some things that are going to be obligations of a firm after CFTC/NFA registration. Bylaw 1101 states that an NFA member can only conduct futures related business with other NFA members.

It is a bit hard to swallow, but it is a self-policing mechanism that the NFA is using to ensure that they have an eye on everyone who’s operating in this space.

When it comes to third parties soliciting on your behalf, they meet the definition of an associated person. Where that associated person gets sponsored is probably the next question. Are you going to sponsor them directly? If you are, then you need to supervise them. So are they going to be on location at your main office, or are they going to be remote, and therefore you have a branch office situation? Or do you make the third party marketer or their firm register with the NFA so that they can be the sponsor?

There’s a little bit of growing pains here for people that are used to these relationships as it relates to the Advisers Act. We need to take the solicitation rule a little farther here, and consider Bylaw 1101.

Q. Can we only submit physical fingerprint cards?

RG: Generally speaking, the NFA only accepts physical fingerprint cards. If you happen to live in Chicago and can walk over to their office and use the electronic machine they have in their office and finish the process on site with them, then you don’t need to use physical fingerprint cards.

SB: Another workaround is to find a vendor that can submit information electronically to FINRA. FINRA will then get the information over to the NFA, or you will need to do that yourself, but it is another workaround.