In an effort to better understand and monitor the financial health of certain members of the National Futures Association (“NFA”), the NFA has submitted a proposal to the Commodity Futures Trading Commission (“CFTC”) that would require commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”) to report additional information about their financial condition on a regular basis.  The recent proposal comes two years after NFA previously sought comments on possible minimum net capital requirements for CPOs and CTAs.  Financial reporting may not, at first blush, seem as onerous as minimum net capital requirements.  However, financial reporting will nonetheless require the careful attention and additional resources of CPOs and CTAs to calculate and report this information on an ongoing basis, as well as create additional recordkeeping requirements.   

The NFA proposal would amend NFA Rule 2-46 and adopt a new interpretive notice, NFA Compliance Rule 2-46: Reporting Financial Information on NFA Forms PQR and PR.  In this Client Alert, we examine some of the requirements of the NFA proposal.

The proposal would require CPOs and CTAs to provide additional financial information through the quarterly and annually filing of the Form PQRs for CPOs and Form PRs for CTAs.  Balance sheets, statements of income and other financial documents would not need to be filed with NFA.  Instead, additional financial information would be provided in the form of two ratios: (i) the Current Assets/Current Liabilities (CA/CL) Ratio, and (ii) the Total Revenue/Total Expenses (TR/TE) Ratio.  In its announcement, NFA stated that the (CA/CL) Ratio is designed to measure a firm’s liquidity while the (TR/TE) Ratio is designed to measure a firm’s operating margin. 

For the first ratio, “Current Assets” would include those assets that can be converted to cash within one year including cash, marketable securities, short-term investments, accounts receivables, and a CPO’s interest in a fund.  “Current Liabilities” would include liabilities expected to be paid within a year such as accounts payable, accrued expenses, payroll liabilities, income tax liabilities, and interest payable.  Long-term liabilities not due within a year would not be included in the calculation.

For the second ratio, “Total Revenue” is gross income from a firm’s normal business activities before any expenses have been deducted.  “Total Expenses” generally are costs associated with doing business and include wages, salaries, rent, utilities, depreciation and bad debts. 

Although a firm may be required to report the (TR/TE) Ratio on a quarterly basis, the ratio must reflect Total Revenue earned and Total Expenses incurred over the last 12 months.

Both ratios must be calculated according to generally accepted accounting principles or another internationally recognized accounting standard, consistently applied.  Additionally, both ratios must also be calculated on an accrual basis meaning that revenue should be included when it is earned (not actually received) and an expense should be included when it is incurred (not actually paid).  CPOs and CTAs that are owned by a holding company may elect to report the ratios at the parent level provided this is noted on the relevant Form PQR or Form PR.  Firms must also maintain sufficient records to demonstrate how the ratios were calculated.  In its proposal, NFA does not specify what type of records would be sufficient, but presumably they could consist of typical accounting records kept in the normal course of business, and would not need to be audited.

In its announcement, NFA indicated that it is not prescribing any minimum ratios that firms must meet.  Rather, NFA will use the information to assist in determining a firm’s risk profile and to identify firms that may be facing financial difficulties.  Presumably, a higher risk profile and/or the identification of financial difficulties could increase the likelihood of an NFA audit.  Additionally, while a poor ratio will not lead to disciplinary action, NFA cautioned its members that providing materially false or misleading information as to a firm’s financial condition could result in NFA rule violations and disciplinary action.

The NFA proposal was supported by the CPO/CTA Advisory Committee and unanimously approved by NFA’s Board of Directors on August 18, 2016.  It is in the discretion of the CFTC whether it will allow comments on the proposal, and traditionally, the CFTC has not had comment periods for NFA proposed rule amendments.

Nonetheless, members of the general public and industry participants may question the need, in the first place, for this type of financial reporting by CPOs and CTAs.  While an argument could conceivably be made with respect to the financial reporting of CPOs due to their control over investors’ funds (but even then, some may question the basis for the regulatory intrusion), the need for the financial reporting of CTAs is less apparent.  Assuming the amended rule and interpretive notice are adopted without comments or further revisions, we anticipate that they will become effective sometime in 2017.