Dec 23, 2011 In counseling Commodity Trading Advisor (“CTA”) and Commodity Pool Operator (“CPO”) registrants trading both futures and/or forex, we routinely come across many of the same questions. When we repeatedly hear the same inquiries from our clients, it’s safe to assume further clarity is needed within the industry. Accordingly, in this publication we intend to address the following frequently asked question: “How must I present hypothetical and/or proprietary performance as a Commodity Futures Trading Commission (“CFTC”) registrant and National Futures Association (“NFA”) member?” By the end of this piece, we hope to have provided your CTA or CPO with the clarity it needs to present the aforementioned performance correctly. Interested readers should also see our previously published article concerning Commodity Futures & Forex Promotional Materials, which also briefly touches on this matter. As always, the following information is not intended to be all-inclusive or constitute legal advice. If your firm would like assistance in drafting its performance or promotional materials, we recommend that you contact a competent industry professional or legal advisor to discuss your requirements in light of your unique circumstances. Hypothetical Trading Results If you’re a CTA or CPO, then your hypothetical performance cannot be presented for any trading program that has conducted at least three months of actual client or proprietary trading. In addition, if shown, it must be accompanied by NFA’s prescribed statements regarding hypothetical or simulated performance results. Hypothetical performance must also include comparable information regarding the pastperformance of all customer accounts directed by the Member (CTA, CPO, Associated Person, Trader etc.) pursuant to a power of attorney or letter of direction over the past five years. Furthermore, if the Member has less than one year of experience directing customer accounts, the past performance of the Member’sproprietary trading for the past five years must be included in the materials. NFA has created the following two-part disclosure standard: 1) If a CTA or CPO intends to include hypothetical trading results, and if they have other programs’ performance to also show, the CTA does not need to list any proprietary trading performance; or 2) If a CTA or CPO intends to include hypothetical trading results, but does not have any other programs’ performance to also show, the CTA must include all proprietary performance for the last five years. In short, it can be very challenging to properly display hypothetical returns as a CTA and/or CPO. Relevant Regulations? Do the rules above seem unfamiliar? Can’t find them in the CFTC’s regulations? For those of you that were ambitious enough to look into the rulebooks – but were unable to find the above-listed regulations – don’t fret. The reason you were unable to find these regulations is simple – To be blunt, NFA made up the “5 year rule.” When we raised this issue with NFA, we were informed by the self-regulatory agency that it would be issuing an interpretative notice explaining its reasoning “very shortly.” For our benefit, NFA explained its “5 year rule” as follows: Pursuant to CFTC Reg. 4.34(o), “Nothing … shall relieve a CTA from any obligation under the Commodity Exchange Act [“CEA”] or the regulations thereunder, including the obligation to disclose all material information to existing or prospective clients even if the information is not specifically required by such sections.” Based on this language, NFA has interpreted the phrase “all material information” to include situations in which a CTA is attempting to show hypothetical trading results without also showing its actual trading results. Hence, the aforementioned requirements discussed above. Based on this NFA restriction, in addition to other reasons, we generally do not recommend the use of hypothetical results in promotional materials for any reason. This extends to the inclusion of such results within disclosure documents as well. The proper use of hypothetical returns can be very difficult to substantiate and properly represent since their very presentation is subjective. Furthermore, such results become obsolete shortly after trading begins (90 days). As a result, in the vast majority of cases, the presentation of hypothetical performance simply isn’t worth the effort or the risk. Proprietary Trading Results Similar to the discussion above pertaining to hypothetical trading results, NFA likewise applies CFTC Reg. 4.34(o) with respect to intended disclosures concerning proprietary trading results. For instance, it is NFA’s position that if you choose to include any proprietary trading results (regardless of whether you intend to include hypothetical results) then you must include all proprietary trading results. Understandably, NFA does not want any cherry-picking of trading results shown to investors – hence the requirement to show all prop results. However, NFA takes this position to the extreme and has even required our clients to include hedge trading accounts in their performance presentations! Regardless of how little sense this may make from a materiality point of view, NFA has held firm to this position on a number of occasions. The moral of the story is that if you want to show some proprietary trading results, then you must show all proprietary trading results. We have found this to be the case even when the proprietary trading results are for programs entirely different from – and even potentially contrary to – the trading program being offered. Although we strongly disagree with NFA’s position on this, unless NFA further clarifies what must be included in a subsequent notice, many disclosure documents containing proprietary trading results will continue to be misleading to clients. This, in our opinion, is especially true for CTAs and CPOs that test systems in live trading environments with proprietary money before offering them publicly. Further Guidance Understanding and complying with these trading performance disclosure rules is crucial to your firm’s ability to effectively market its trading results while also complying with applicable rules and regulations. As a result, it would be prudent to contact a regulatory professional like Turnkey Trading Partners (TTP) to assist you in this effort. TTP has the business acumen, as well as important relationships with legal professionals, such as Henderson & Lyman of Chicago, to provide you with the guidance you need to tackle these, as well as other, performance disclosure restrictions. -James Bibbings and Nicole Kuchera ________________________________________ James Bibbings is the President and CEO of Turnkey Trading Partners (TTP), a firm that supports all commodity and forex specific regulatory and business needs. Prior to founding TTP, Bibbings worked with the National Futures Association (“NFA”) as a supervising auditor. During his time with NFA he was involved in approximately 100 investigative audits and was able to gain a deep working knowledge of FDM, FCM, IB, CTA, and CPO operations. Since departing from NFA, Bibbings has owned and operated an independent introducing brokerage, spoken at a variety of alternative investment conferences, and participated in international forums on proposed CFTC regulatory requirements. He has also provided content for Bloomberg, MSN, The Wall Street Journal’s Market Watch Yahoo, Financial Times, FX Street, FinAlternatives, Safe Haven, Financial Sense, Forex Journal, and many other highly acclaimed investment publications. Two highly sought after informational pamphlets regarding futures and forex registration authored by Bibbings are currently available for free upon request through his company website. If you have any questions or comments for Bibbings he can be reached directly by email email@example.com and would love to hear from you. Nicole Kuchera, JD, LLM is an Associate in Henderson & Lyman’s Financial Services Practice Group. She concentrates her legal practice on transactional and litigation support for securities, futures and derivatives industry clients, such as Introducing Brokers, Commodity Trading Advisors, Commodity Pool Operators, Broker-Dealers, Investment Advisers, Futures Commission Merchants, and Forex Dealer Members. Ms. Kuchera counsels clients regarding a wide range of compliance and regulatory matters involving the rules and regulations of the SEC and the CFTC, as well as self-regulatory organizations and exchanges. She also represents financial services industry clients in a wide range of litigation matters in various forums, including state and federal courts and in industry arbitrations and mediations. Ms. Kuchera also represents clients in general corporate matters, such as business formation, licensing and industry registration.