On Oct. 16, 2008, the National Futures Association (“NFA”) issued “Notice to Members I-08-26” (“Notice”)1 advising commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”) that are NFA members (“Covered Members”) that NFA Compliance Rules 2-41 and 2-42 (“Rules”) had been approved by the Commodity Futures Trading Commission (“CFTC”), effective Nov. 30, 2008. With certain exceptions discussed below, the Rules will apply to Covered Member CPOs offering funds that trade “forex,” as defined in NFA Bylaw 1507(b), and Covered Member CTAs managing, directing or guiding a client’s forex trading (“Covered Forex Activities”). CPOs and CTAs that are exempt from CFTC registration as such (e.g., pursuant to CFTC Rule 4.13(a)(4) or 4.14(a)(10)) and that are not, therefore, NFA members, will not be subject to the Rules.2

Unless a Covered Member is exempt from the Rules, it will be required to provide fund investors and prospective clients with the disclosures currently required under the CFTC’s Part 4 regulations and, in the case of a Covered Member CPO, to provide periodic account statements and an annual report to fund investors. The Rules will not apply to (1) Covered Members’ spot or forward (i.e., non-futures) forex trading, (2) Covered Member CPOs operating funds that are “eligible contract participants” (“ECPs”), with two limited exceptions; or (3) Covered Member CTAs managing, directing or guiding an ECP client’s forex trading.

Background

In its letter accompanying the proposed rules, the NFA noted that in the past two years, it has noticed a significant increase in the number of CTAs that deal exclusively in forex.3 Notwithstanding that under the current forex regulatory structure, CFTC and NFA disclosure document requirements do not apply to such CTAs, an increasing number of them have voluntarily filed materials with the NFA that they characterized as disclosure documents but that did not comply with CFTC and NFA disclosure document requirements.4 The Rules represent an effort to bring Covered Forex Activities under the registered CPO/CTA disclosure/reporting regime.

The Rules

Rule 2-41 will require Covered Members that are not exempt from the Rule to (1) provide prospective clients and fund investors with a disclosure document complying with CFTC rules regarding general and performance disclosures and containing a forex-specific Risk Disclosure Statement and (2) file the disclosure document with the NFA prior to its use.5

Rule 2-42 will require Covered Member CPOs to provide periodic (monthly or quarterly) account statements and an annual report to the pool participants. In short, the Rules generally impose on Covered Members the same requirements for Covered Forex Activities that currently exist for non-forex futures and options, unless one of the exemptions discussed below applies.

Covered Forex Activities

The Rules apply with respect to “forex,” as that term is defined in NFA Bylaw 1507(b). The term “forex” is defined in NFA Bylaw 1507(b) as:

(1) foreign currency futures and options and any other agreement, contract, or transaction in foreign currency that is offered or entered into on a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis;

(2) offered to or entered into with persons that are not eligible contract participants as defined in Section 1a(12) of the Act; and

(3) not executed on or subject to the rules of a contract market, a derivatives transaction execution facility, a national securities exchange registered pursuant to Section 6(a) of the Securities Exchange Act of 1934, or a foreign board of trade.

However, NFA Bylaw 1507(b) specifically excludes from the “forex” definition:

any security that is not a security futures product, any contract of sale that results in actual delivery within two days, or any contract of sale that creates an enforceable obligation to deliver between a seller and buyer that have the ability to deliver and accept delivery, respectively, in connection with their line of business, unless the transaction involves a futures contract or an option.

In summary, the Rules will apply only to forex trades with an element of future delivery or leverage or financing: neither spot market nor forward forex transactions will be covered.

Exemptions from the Rules’ Coverage

The Rules will not apply to CPOs or CTAs undertaking Covered Forex Activities on behalf of ECPs6 (with two exceptions), or to CPOs or CTAs that are also certain regulated entities listed in NFA Bylaw 306(b).7 This ECP exemption from the Rules does not apply to a CPO of a fund that is an ECP solely under Section 1a(12)(A)(v)(II) or (III) of the CEA, although relying on Section 1a(12)(A)(v)(I) is permitted. A fund is an ECP under Section 1a(12)(A)(v)(I), (II) or (III) if it is acting for its own account and is:

a corporation, partnership, proprietorship, organization, trust, or other entity—

(I) that has total assets exceeding $10,000,000;

(II) the obligations of which under an agreement, contract, or transaction are guaranteed or otherwise supported by a letter of credit or keepwell, support, or other agreement by an entity described in subclause (I), in clause (i), (ii), (iii), (iv), or (vii), or in subparagraph (C); or

(III) that—

(aa) has a net worth exceeding $1,000,000; and

(bb) enters into an agreement, contract, or transaction in connection with the conduct of the entity’s business or to manage the risk associated with an asset or liability owned or incurred or reasonably likely to be owned or incurred by the entity in the conduct of the entity’s business.

As noted above, the Rules become effective on Nov. 30, 2008. However, given that they do not apply with respect to exchange-traded forex contracts, to non-NFA member CPOs or CTAs, or to CPOs or CTAs engaging in Covered Forex Activities on behalf of ECPs (with the two limited exceptions discussed above), their application is extremely limited in scope.