If you are member of the National Futures Association (“NFA”), you have probably heard that you are required to abide by NFA’s Bylaw 1101 (“Bylaw 1101”) due diligence obligations in connection with the operation of your firm. Bylaw 1101 prohibits NFA Members (“Members”) from conducting business with or on behalf of non-NFA Members. In this regard, NFA imposes strict liability on its Members for violations of Bylaw 1101, with enforcement cases primarily issued in instances where the NFA staff believes that the Member “knew or should have known of the violation.” The determination of whether a Member “knew of should have known of the violation” largely hinges upon the procedures that a Member has in place and its diligence in following such procedures. When referenced in this article, the term “person” includes entities and other business structures.
In an effort to alleviate some confusion that you may have with respect to your above-listed obligations, this article provides a brief summary of Bylaw 1101 and NFA’s FAQ concerning Bylaw 1101 and also describes best practices in handling common issues triggered when applying Bylaw 1101, such as when dealing with: (1) lead generators, (2) distributors, (3) third party checks, (4) investors, (5) persons claiming to be exempt or excluded from registration, (6) delegated commodity pool operators and (7) foreign persons.
Bylaw 1101 Obligations Generally
What is NFA Bylaw 1101 and how does it affect me as a Member? In short form, Bylaw 1101 prohibits Members from doing business with or on behalf of non-members that are required to be registered with the Commodity Futures Trading Commission (“CFTC”), pursuant to the Commodity Exchange Act, as amended (the “CEA”). The most common CFTC registration categories are for a futures commission merchant (“FCM”), introducing broker (“IB”), commodity trading advisor (“CTA”) and commodity pool operator (“CPO”).
The fundamental determinations necessary for complying with Bylaw 1101 are: (1) whether you are doing business with or on behalf of a person that is required to be registered with the CFTC and (2) if such registration is required, whether such person is also an NFA Member. You can review NFA’s BASIC system (found here: https://www.nfa.futures.org/basicnet/welcome.aspx) to verify whether the person is CFTC registered and an NFA Member. If NFA’s BASIC system indicates that a person is CFTC registered and an NFA Member, your initial Bylaw 1101 compliance obligation is satisfied (although you will have an ongoing obligation in light of new facts). If a person is not registered, however, your obligation will continue such that you will need to ascertain why CFTC registration is not required, such as due to an exemption, exclusion or otherwise. Similarly, if a person is CFTC registered but not an NFA Member, you will need to determine why that person is not an NFA Member. As part of this process, you should always remember to document your diligence review in coming to such conclusions.
The remainder of this article will tackle several common scenarios in which the applicability of Bylaw 1101 can prove to be challenging and thus a more extended discussion as to each scenario is warranted. This article does not purport to be an all-encompassing summary of Bylaw 1101 considerations. Rather this article is meant to serve as an initial reference for Members to consult with in regards to their Bylaw 1101 due diligence obligations.
Bylaw 1101’s Application When Dealing with Lead Generators
Why would I need to determine if a lead generator is CFTC registered and an NFA Member? A lead provider may be required to be CFTC registered and an NFA Member based on the way in which it generates the leads. For example, if you purchase leads from a provider that generates leads solely incidental to some other business purpose (e.g., a subscription list), then it is unlikely that such provider would be required to be registered as an IB. On the other hand, if you find out that the leads were generated from a provider using any type of advertisement soliciting investments in futures, one of whose business purposes is the generation and sale of the leads, then such party is most likely required to registered with the CFTC as an IB and to become an NFA Member.
If you decide to proceed with a particular lead provider, you will want to include a representation from the lead provider in your business agreement that specifies that such person is either not subject to CFTC registration, is properly registered with the CFTC and is an NFA Member, or is exempt from registration and NFA Membership. Such representation should also comport with your understanding of the facts.
Bylaw 1101’s Application When Dealing with Distributors
Why would I need to determine if a distributor is CFTC registered and an NFA Member? If you are a CPO Member, you need to analyze whether a person that seeks to distribute interests in your commodity pool is required to be registered with the CFTC as IB and is an NFA Member. In this regard, you will want to include a representation from the distributor in your distribution agreement that specifies that such person is either not subject to CFTC registration, is properly registered with the CFTC and is an NFA Member, or is exempt from registration and NFA Membership. Such representation should also comport with your understanding of the facts.
Bylaw 1101’s Application with Receiving Checks from Third Parties
What should I do if I start receiving checks from third parties for investment by my investor? If you start to receive checks from multiple parties for one account (where there does not appear to be a family relationship), your investor may in fact be acting as an unregistered FCM or CPO. Before accepting the third party check for investment, you should carefully review the reason for the separate check and assess the relationship between the parties. If you accept the check for investment, you should document both the reason for accepting it and the steps you took to investigate the situation.
Bylaw 1101’s Application When Dealing with Investors
Why would I need to determine if a potential investor in a commodity pool or managed account is CFTC registered and an NFA Member? A Member is required to verify the status of those persons that seek to become an investor in a commodity pool or a customer of a CTA for the trading of a commodity account. Thus, if you are CPO or CTA Member, you are required to determine whether the investor is required to be registered with the CFTC as a CPO (or FCM) and whether such person is an NFA Member.
In this regard, if you are a CPO Member managing a private fund, you should include in your subscription materials affirmative representations concerning the potential investor’s registration, exemption or exclusion status. Likewise, if you are a CTA Member, you should include similar affirmative representations from the potential customer in your investment management agreement. You should also include a covenant from the investor to immediately notify you in writing if any warranty or any information contained in the subscription document/investment management agreement becomes untrue. In either case, if an investor represents that it is not required to be registered because it satisfies a particular exemption or exclusion and such representation does not appear to be congruent with the facts, you should ask additional questions to seek to determine whether registration is in fact required.
Bylaw 1101’s Application When Dealing with CPOs/CTAs Exempt from Registration
How does Bylaw 1101 apply when I am dealing with a CPO or CTA that tells me that they are exempt from CFTC registration? NFA expects a Member to use reasonable steps to identify those persons who currently claim an exemption from CPO/CTA registration with whom the Member transacts customer business. This process is fairly simple where a CPO or CTA at issue has made a notice filing of their exemption/exclusion with NFA. For instance, if a CPO or CTA is claiming an exemption from CPO registration under CFTC Rules 4.13(a)(1), 4.13(a)(2), 4.13(a)(3) or 4.13(a)(5), an exclusion from CPO registration under Regulation 4.5 or an exemption from CTA registration under 4.14(a)(8), you can check to determine that this party has properly affirmed their exemption/exclusion on NFA’s BASIC system. If NFA’s BASIC system indicates that the person is exempt or excluded from registration as indicated, your initial Bylaw 1101 compliance obligation is satisfied (although the obligation is ongoing).
If a person is not listed as exempt or excluded from registration, your obligation will continue such that you will need to ascertain whether a self-executing exemption or exclusion applies. “Self-executing” exemptions or exclusions mean that no filing with NFA is necessary for the CPO or CTA to operate under the desired exemption or exclusion. By consequence, self-executing exemptions and exclusions are harder to verify. Under your Bylaw 1101 obligations, at a minimum, you are required to take notice and conduct additional due diligence if the facts tend to be contrary to the claimed exemption or exclusion status. In all cases, we recommend that you obtain the CTA or CPO’s written confirmation that the claimed exemption or exclusion is applicable to their facts.
Below are some examples of CTA and CPO exemptions and exclusions that are self-executing, and thus will not show up on NFA’s BASIC system even if they are applicable to the CTA or CPO:
- 15 Persons CTA Exemption. Section 4m(1) of the CEA provides an exemption from registration for a person who, in the preceding 12 months, has not furnished commodity trading advice to more than 15 persons and who does not hold himself out generally to the public as a CTA. Because this exemption is self-executing (and thus does not require a notice filing or annual affirmation), if you are dealing with a CTA claiming exemption under 4m(1), you should take note if any facts (such as website representations or otherwise) seem to be contrary to the CTA’s claim that the exemption applies. It would also be beneficial to obtain a written representation from the CTA that it satisfies this exemption and that it will immediately notify you in writing if the exemption no longer applies.
- Investment Adviser CTA Exemption. Section 4m(3) of the CEA provides an exemption from CTA registration for a person: (1) who is registered with the Securities and Exchange Commission (the “SEC”) as an investment adviser, (2) whose business does not consist primarily of acting as a CTA and (3) who does not act as a CTA to any investment trust, syndicate, or similar form of enterprise that is engaged primarily in trading in any commodity. In this regard, the SEC’s database should reflect whether such person is registered as an investment adviser. You should take note if the facts do not seem to support the CTA’s claim that their business does not consist primarily of CTA activities, such as contradictory information that you may happen to notice on their website, promotional materials, Form ADV or otherwise. It would also be beneficial to obtain a written representation from the CTA that it satisfies this exemption and that it will immediately notify you in writing if the exemption no longer applies.
- Various other CTA Exemptions Under CFTC Rule 4.14. The relief available under CFTC Rules 4.14(a)(1) through (7) and (9) is also self-executing. To satisfy your Bylaw 1101 responsibility in such a situation, you will want to take note if any facts tend not to support the CTA’s claim with respect to a particular exemption. It would also be beneficial to obtain a written representation from the CTA that it satisfies this exemption and that it will immediately notify you in writing if the exemption no longer applies.
- Certain Trading Vehicles Excluded as Commodity Pools. CFTC Rule 4.5 provides a self-executing exclusion for certain trading vehicles from being construed as “commodity pools.” In satisfying your Bylaw 1101 obligations under this scenario, you should take notice and conduct additional due diligence if the facts do not seem to comport with the party’s claim with respect to this exclusion. It would also be beneficial to obtain a written representation from the party that the vehicle satisfies this exclusion and that it will immediately notify you in writing if the exclusion no longer applies.
Bylaw 1101 Considerations When Dealing with Delegated CPOs
What is a “Delegated CPO?” What I am supposed to do if the CPO of a commodity pool that I intend to do business with tells me that they are the pool’s “delegated CPO?” If a Member is approached to do business with a particular pool, the Member is required to determine whether the CPO of the pool is CFTC registered and an NFA Member. In this regard, occasionally the CPO of the pool may tell you that they are the “delegated CPO” of the pool. You may thereafter ask yourself: (1) what does this mean and (2) how am I supposed to handle this situation from a Bylaw 1101 perspective. Let’s now address each question in turn.
As to the first question, a “delegated CPO” simply describes a situation where another CPO (most commonly the directors or general partner of a commodity pool) decides to delegate certain of its responsibilities as the CPO of a commodity pool to a registered CPO (the “Delegated CPO”). The Delegated CPO thereby accepts all investment management authority with respect to the commodity pool, and will be regulated as the CPO for the pool accordingly. As one of the conditions for such delegation, persons that delegate their CPO authority to the Delegated CPO will no longer be responsible for the investment management of the pool, but may remain jointly and severally liable for any violation of the CEA or CFTC regulations in connection with the operation of the pool.
As to the second question, in conducting your Bylaw 1101 due diligence, you can confirm that the person is the Delegated CPO for the pool by locating the pool name’s under the CPO’s pool exemption filings link on NFA’s BASIC system under “Delegated Pools.” If you find the pool’s name listed under the CPO’s “Delegated Pools” list, you will have generally satisfied your Bylaw 1101 obligations with respect to the CPO of the pool (absent knowledge of any contrary information, etc.).
If, however, the pool is not listed under CPO’s “Delegated Pools” list, you will need to conduct additional diligence to comply with Bylaw 1101. For instance, it may be the case that since CPOs only report their delegated pools on an annual basis, the Delegated CPO may have simply not yet been required to report the delegation with NFA – and this is why the delegation is not reflected yet on NFA’s BASIC system. If the Delegated CPO informs you that this is the case, and that NFA BASIC’s system simply is not yet up-to-date with respect to the delegation, we recommend that you obtain a written affirmation from the Delegated CPO concerning such delegation. You may also wish to request a copy of the delegation agreement itself.
Bylaw 1101’s Application When Dealing with Foreign Persons
Why would I need to determine if a foreign person is CFTC registered and an NFA Member? Foreign persons may be required to be registered with the CFTC and an NFA Member when engaging in activities that are related to the United States. If a foreign person is not registered with the CFTC, you may wish to first consult with the table provided below (which can also be found on NFA’s website at: https://www.nfa.futures.org/NFA-faqs/compliance-faqs/bylaw-1101/index.HTML) as part of your Bylaw 1101 analysis. This handy table shows when a person that conducts activities generally requiring registration is required to be registered as an FCM, IB, CPO or CTA, etc. based on the locations of the person, its customers and the exchanges on which contracts will be traded. Exemptions may, of course, apply.
If you conclude that a foreign person is conducting activities that appear to require registration based on the above table, you will want to inquire more about why the foreign person believes that CFTC registration and NFA Membership is not required and obtain representations concerning the same where deemed appropriate.
As evidenced by the above scenarios, complying with Bylaw 1101 due diligence obligations can be a challenge for even seasoned Members.