Nov 30, 2022 By: Turnkey Trading Partners Often when CFTC or NFA compliance publications are written they cover the most recent industry topics and events. Interestingly though, Turnkey finds that many firms have audit deficiencies in areas that might be considered “simple” or “elementary” compliance matters. One such area that we have seen an uptick in confusion over is who at a firm is required to be listed as a principal with NFA? What is a Principal? In the eyes of the CFTC and NFA principal status is determined at a high level by the following: For Individuals; The individual’s ability to control a registrant’s business activities; The individual’s formal title or position with a registrant; and/or The individual’s ownership or financial stake in a registrant. For entities; Because it is a general partner of a partnership; and/or Based on its ownership or financial stake in a registrant. Who are Principals? For most firms, defining who principals are is pretty simple. Identifying the primary owner or controller of a brokerage and trading firm is relatively straight forward. It is also often trivial to identify who can control the registrant’s business activities based upon employment titles and responsibilities. For other more institutional operations with complex ownership and organizational structures or with varying business lines and units this isn’t always so easy. Over the years Turnkey has identified the two most common ways firms incorrectly identify and list principals with NFA. One of these occurs at large organizations, the other occurs at smaller organizations. Most Frequent Small Firm Error When evaluating who may qualify to be a principal small firms often do evaluate NFA’s website on principalship. When they review the site they often gloss over or don’t understand one critical element in the litmus test of principalship: “An individual who is entitled to receive 10% or more of an applicant or registrant’s net profits”. The so called “10% of net profits” obligation is one that is very often missed or disregarded when it comes to broker payouts. Small firms typically have only a handful of brokers. They usually understand the primary owners of a business that have 10% or more equity need to be principals. What they do not understand is that often their largest producing brokers generate commission income that can exceed 10% of net profit. While this can happen at larger organizations, typically larger groups have more diversified revenue across larger teams or business units. Firms that have several large brokers should evaluate whether or not commission payouts to those brokers may qualify them to be principals under this widely missed nuance of the principalship obligations. Most Frequent Large Firm Error Large organizations can run into trouble with the 10% of net profits issue noted above. Often though this is not the primary principalship issue for more institutional groups. For sophisticated organizations principalship listing errors often come from poor communication throughout the organization. Often the team working for a regulated business unit is not privy to the overall corporate organizational chart. They may not be alerted to structural changes to a firm’s legal operations. They also may not have a good handle on how corporate treasury and banking functions work. There very often is a knowledge gap between the people that understand CFTC and NFA obligations, and larger organization operational teams. Large firms should ensure that copies of corporate organizational charts are available to the primary control persons running a CFTC regulated entity. These org charts should diagram how money flows between entities and what percent equity each entity may hold in every other. NFA expects that profits (as noted above) as well as equity over 10% be sourced and traced throughout an organization. Anyone or any entity that either directly or indirectly breaks this threshold should be a principal. Another area of concern for larger organizations is that very often corporate policy mandates specific finance and treasury functions. Part of these functions may require certain officers have their names and authority be placed on file for all banking relationships and/or material business agreements. This can become problematic if the registered reps and listed principals at a CFTC registrant and NFA member firm don’t actually have control over certain business functions. Place corporate level executives on divisional level registrant agreements may result in senior persons not being involved in brokerage or trading activities having to be listed as principals. Conclusion When CFTC registrant, NFA member firms are started legal counsel, private regulatory consultants such as Turnkey Trading Partners, and regulators generally evaluate AP and Principal registration needs. As time goes on however these needs can be forgotten and disregarded; particularly the 10% net income threshold obligation above. At least once annually when completing the NFA Self-Exam Checklist firms should re-evaluate AP and Principal status across the organization. This will ensure that any changes in business activity or structure are properly reflected in the firms registration records. If you have specific questions related to this article please contact Turnkey Trading Partners for assistance. We’d love to speak with you and learn more about your unique concerns.