Aug 22, 2019 Authored By: Greg Baracy – Turnkey Trading Partners Turnkey Trading Partners (“Turnkey”) has conducted onsite office reviews of Commodity Futures Trading Commission (“CFTC”) and National Futures Association (“NFA”) registered firms for more than a decade. After hundreds of these visits Turnkey has uncovered just about everything one can imagine. Interestingly, when a compliance concern comes up, every firm we have worked for, whether it has been an Introducing Broker (“IB”) or Futures Commission Merchant (“FCM”), says the same basic thing: “We assumed that our company policies and procedures were being followed. We trusted our associated person’s (“AP”) experience and past history running the GIB or Branch office location. We can’t believe these problems were happening for as long as they were.” Recently NFA published new guidance about its expectations for how member firms should supervise outside office locations. In summation, NFA’s guidance instructed member firms to use a “risk based” approach with respect to how outside offices are evaluated. Turnkey predicted NFA would make such a move when we authored an article on the topic in October of 2018. Before rushing to make changes to your firm’s supervisory and outside office review program, please consider these additional thoughts about where outside office risks can pop up even when they are least expected. Not All Locations Are Created Equal Each outside office location presents unique circumstances which should be considered with respect to how the location is supervised. Some of these circumstances may not be simple to identify. The rest of this article will rely on the following example. Quickly ask yourself – Which of the two offices described below carries more potential compliance and business risk? Office A: The location is relatively new and is very active. It employs several brokers, and places hundreds or even thousands of orders on a daily basis. The staff has industry experience and no customer complaints have been received. The location is typically one of the highest revenue producing offices and opens a handful or more accounts each month or; Office B: The location has been with the company for many years. It works strictly on the basis of referrals from local farmers or personal relationships. The location primarily brokers agricultural futures and options and might place a half dozen hedge orders over the course of a month or even an entire year. There are one or two APs registered at the location who have been registered for years. The office is opening few new accounts, if any, and in many ways appears relatively inactive. Most industry compliance programs, and even the models NFA uses, would likely identify Office A as being a higher risk location than Office B. While this may be the prevailing industry assumption, Turnkey has found this assumption can be incorrect. In fact, it has been Turnkey’s experience, that Office A type locations may actually be less risky than Office B type locations when considering both compliance and business risk. Often, larger Type A office locations have the resources to implement more robust compliance and operational tools relative to smaller Type B locations. In addition to this, larger locations typically have established, proven, and scalable business processes in place. This is often not the case at smaller locations that are more dependent on high touch, one at a time solutions. Higher Risks At Smaller Offices? Office B from above is fairly typical of most branch office and GIB locations within the commodity interest industry today. These smaller, remote, so called “hedge” offices, in many cases don’t generate enough revenue to cover operating costs from brokerage commissions alone. This often means that the operators of these locations also have outside business interests which generate offsetting revenues. Examples of common affiliated businesses Turnkey has seen range from crop marketing services and industry newsletters to owner operated physical delivery facilities, processing centers, and even insurance businesses. While some of these operations may be synergistic to a location’s brokerage efforts, they also carry with them out sized compliance and business risks. Frequently, unregulated business activities become commingled with regulated activities. When this happens, it can lead to major headaches. Somewhat ironically, Office B type locations that don’t have outside business operations may carry even more risks. In particular, if a location has no other source of revenue, it can become increasingly desperate over time. Locations with no history of malfeasance and a dwindling business can begin to cut corners if an opportunity presents itself. Turnkey has seen offices in these circumstances begin to make handshake deals with long time relationships when they shouldn’t. In one instance, we identified a location making loans to customers to cover margin calls. In another location the main associated person began to secretly pay referral fees to people in the community for business leads. Another common risk at smaller office locations is that overtime they can begin to get more aggressive with their marketing efforts. Office B type locations, especially those with outside business interests, may begin to operate under an unofficial assumed name. They also may place radio, newspaper, television or other local adds to get more exposure in their regional communities. In addition, they might start contributing to some type of email or other industry-based news distribution source. Some just simply decide to begin an online marketing campaign via their personal social media accounts. Frequently, Office B locations begin these lead generation efforts and do not think to communicate with their supervising office about the effort. This can, and often does, create a myriad of compliance problems. While there may not be anything nefarious or even non-compliant about the content being produced, that does not mean these types of actions are worth the associated compliance risks. Record Keeping Office B type locations and operators are generally very smart. Many of them have been in the industry for years and know the routine. They realize that the type of business they conduct means they will be less heavily scrutinized. This can, and often does, lead to a lackadaisical approach to compliance. After years of limited scrutiny from both NFA as well as their respective supervisory firms some will do just enough to get by. Office B locations also typically have a cozy relationship with their onsite reviewer. This is largely possible because reviewers frequently are part of the same organization as the office they are visiting. These reviewers visit the location year after year and rarely turnover or rotate. Turnkey has found, in such circumstances, these offices regularly fail to capture or maintain necessary and critical record keeping items. Examples of these items might include communications with clients via email, phone, or chat systems. Similarly, locations of this type often don’t maintain promotional material records and approvals, annual testing documents and attestations, as well as the latest compliance policies. Perhaps the most serious situation Turnkey identifies related to record keeping at Office B locations are undocumented or unacknowledged discretionary trading accounts. Third Party Audit Solutions One of the best ways to supervise both Office A and Office B type locations is to have annual reviews of outside offices conducted by a qualified third-party provider. Third party reviews can ensure that any close relationships, which can develop over time, do not compromise the integrity of the examination process. Similarly, outside office reviews reduce the conflict of interest inherent in maintaining an internal audit department. Lastly, the costs of third-party reviews are negligible relative to the potential regulatory and business risks. Most Office B type locations will complain about any increasing fees they must pay for compliance in general. However, ironically, these locations can also produce a large amount of risk relative to the limited revenues they produce. Turnkey offers outside office review services to some of the leading firms in the commodity interest industry. Our firm has the scale and expertise to reduce location and staffing costs for both FCMs and IBs. Our team of experienced auditors, have evaluated hundreds of locations over the years, we can help identify compliance problems before they become costly regulatory headaches. Turnkey may be somewhat biased and conflicted when we say this, however, we believe third party review truly is the best choice to meet the increasing demands of supervising outside office locations. For more information about how to engage Turnkey to conduct your outside office reviews, please call (312) 324-0040 or email us here. About the Author Greg Baracy has over 15 years of experience in the financial services industry. His expertise spans across many verticals such as investment banking, financial advisory, quantitative and qualitative analysis. His area of focus at Turnkey is in new business origination, customer on-boarding and relationship management. Greg also regularly conducts reviews of customer outside office locations for Turnkey clients. Before joining Turnkey, he managed the Mid-Atlantic, Midwest and Northeast portfolio of municipal issuers for one of the big three Wall Street Bond Rating Agencies. During his tenure, he grew the agencies portfolio to its largest size since its inception. He holds a degree in Economics and Applied Policies from Michigan State University.