[Federal Register: March 13, 2003 (Volume 68, Number 49)]
[Proposed Rules]
[Page 12001-12011]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr13mr03-20]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Part 4
Performance Data and Disclosure for Commodity Trading Advisors
AGENCY: Commodity Futures Trading Commission.
ACTION: Proposed rules.
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SUMMARY: The Commodity Futures Trading Commission (``CFTC'' or
``Commission'') is proposing to amend its rules relating to the
computation and presentation of rate of return information and other
disclosures concerning partially-funded accounts managed by commodity
trading advisors (``CTAs'').
DATES: Comments must be received by April 14, 2003.
ADDRESSES: Interested persons should submit their views and comments to
Jean A. Webb, Secretary of the Commission, Commodity Futures Trading
Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington,
DC 20581. In addition, comments may be sent by facsimile transmission
to (202) 418-5543, or by
[[Page 12002]]
electronic mail to secretary@cftc.gov. Reference should be made to
``Performance Data and Disclosure for Commodity Trading Advisors.''
FOR FURTHER INFORMATION CONTACT: Robert B. Wasserman, Associate
Director, (202) 418-5092, electronic mail: rwasserman@cftc.gov, or
Eileen R. Chotiner, Futures Trading Specialist, (202) 418-5467,
electronic mail: echotiner@cftc.gov, Division of Clearing and
Intermediary Oversight, Commodity Futures Trading Commission, 1155 21st
Street, NW., Washington, DC 20581.
SUPPLEMENTARY INFORMATION:
I. Background
The Commission is proposing to amend several of its rules \1\
affecting the computation and presentation of rate of return
information and other disclosures by CTAs to prospective clients. The
proposed amendments will enable CTAs to disclose past performance as
computed on the basis of the client's nominal account size (the amount
upon which the CTA bases its trading decisions) rather than on the
basis of the actual funds the client has placed in an account subject
to the CTA's control. The amendments will affect past performance
disclosure made by CTAs to prospective clients, and will not affect the
manner in which information is provided to existing clients. Existing
clients will continue to receive information on the status of their own
accounts on an actual cash basis.\2\
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\1\ Commission rules cited herein are found at 17 CFR Ch. I
(2002).
\2\ Commission Rule 1.33 sets forth the requirements applicable
to futures commission merchants (``FCMs'') with respect to reporting
to their customers. Commission rules cited herein are found at 17
CFR Ch. I (2002).
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On August 2, 1999, the Commission published in the Federal Register
\3\ proposed rules regarding the computation and presentation of rate
of return information and other disclosures concerning past performance
of accounts over which the CTA has had trading authority.\4\ No final
action was taken at that time. Now, due to the passage of time,
intervening legislative and other developments, including reevaluation
of certain of the issues involved, the Commission is reproposing these
amendments.
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\3\ See 64 FR 41843 (August 2, 1999).
\4\ Those proposed amendments developed out of rules proposed by
National Futures Association (``NFA'') to permit CTAs to disclose
past performance as computed on the basis of the client's nominal
account size (the amount upon which the CTA bases its trading),
rather than on the basis of the actual funds the client has placed
in accounts subject to the CTA's control. The NFA proposal was also
the subject of a concept release published by the Commission in June
1998 that discussed a number of possible enhancements and
alternatives to the NFA proposal and sought public comment on those
issues. See 63 FR 33297 (June 18, 1998).
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II. Proposed Amendments to Commission Regulations 4.25, 4.33, 4.34 and
4.35
A. Rate of Return Computation
This proposal addresses how to measure advisors' rates of return in
a margin- and leverage-based industry. From the CTA's perspective,
trading is the same for all accounts in a program, regardless of the
amount of actual funds. The use of margin, however, allows clients to
fund accounts with much less in actual funds than the account size that
they have agreed to have the CTA trade. Determination of the amount a
client deposits with an FCM is between the FCM and the client--the CTA
is not part of this decision, nor does it affect the CTA's level of
trading for the client's account. Each existing CTA client will receive
from its FCM reports of the amount of actual funds in the account, the
profits or losses that occur, fees charged, and notice of any margin
calls that may be necessary.
The rules that the Commission is proposing to revise apply to the
disclosure of the CTA's past performance to prospective clients. The
difficulty in basing such performance on actual funding levels arises
primarily from the use of margin, which permits actual funding levels
that may be so minimal as to make a return calculated on that basis
greatly distorted. In addition, clients generally may open accounts
with an FCM of their own choosing and clients in the same trading
program may, in fact, have widely divergent amounts of actual funds
supporting the same level of trading. In order to allow CTAs to present
to prospective clients composite performance results that will be
consistent for the accounts within the program, the Commission is
proposing that the basis for the rate of return calculation be the
amount on which the CTA is making its trading decisions--the nominal
account size.
1. Brief History of Methods Used To Compute Rates of Return
The Commission first required disclosure of the past performance of
CTAs in 1981.\5\ The rate of return for a period for a particular
trading program was defined as the net performance \6\ for that period
divided by the net asset value at the beginning of the period.\7\ At
that time, the practice of partial funding was not common; clients
generally deposited in their accounts with FCMs an amount equal to the
amount that the CTA and its customer had agreed would determine the
level of trading, which subsequently became known as the ``Nominal
Account Size.''
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\5\ See 46 FR 26005, 26009 (May 8, 1981). Pursuant to the
original Part 4 disclosure rules adopted in 1979, CTAs were
permitted, but not required, to disclose their past performance in
accordance with the format specified for commodity pool performance.
44 FR 1918, 1923 (January 8, 1979).
\6\ Commission Rule 4.35(a)(6)(i)(D) currently specifies that
net performance represents the change in the net asset value net of
additions, withdrawals, redemptions, fees and expenses. Commission
Rule 4.10(b) currently defines ``net asset value'' as ``total assets
minus total liabilities, determined in accord with generally
accepted accounting principles, with each position in a commodity
interest accounted for at fair market value.''
\7\ Commission Rule 4.35(a)(6)(i)(A).
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In later years, Commission staff became aware that some CTA clients
were not depositing the full nominal account size in their FCM
accounts. This led the Division of Trading and Markets \8\ to issue
Advisory 87-2, which stated that only funds under the control of the
CTA (``Actual Funds'') could be included in beginning net asset value
(``BNAV'').\9\ Advisory 87-2 stated that ``funds which the client has
promised orally to provide upon request'' (there described as
``notional'' funds) could not be included in BNAV.
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\8\ Following the Commission's reorganization in July 2001, the
Division of Trading and Markets' role with respect to CPOs and CTAs
is now carried out by the Division of Clearing and Intermediary
Oversight.
\9\ CFTC Advisory 87-2 [1986-87 Transfer Binder] Comm. Fut. L.
Rep. (CCH) [para] 23,624 (June 2, 1987). Advisory 87-2 specified
that funds contained in a commodity trading account over which the
CTA has been given trading authority must be included in BNAV, and
set forth the conditions under which funds contained in any other
type of account carried with the FCM could be included in BNAV.
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After Advisory 87-2 was issued, Commission staff were frequently
apprised by industry participants of their concerns regarding the
possible distortions to rates of return calculated based on actual
funds rather than the account size, designated by the client, upon
which the CTA made its trading decisions.\10\ In 1993, the Commission
issued Advisory 93-13, in an effort to alleviate these concerns and to
reach a compromise between the actual funds and the ``notional'' funds
methods of computing performance.\11\
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\10\ These concerns were among the issues addressed by the
Managed Futures Subcommittee of the Commission's Regulatory
Coordination Advisory Committee, which existed from 1990 to 1995.
\11\ CFTC Advisory 93-13, 58 FR 8226 (February 12, 1993). The
term ``nominal account size'' was introduced in Advisory 93-13.
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Advisory 93-13 permitted CTAs to disclose, as their past
performance, the
[[Page 12003]]
rate of return of a ``fully-funded subset'' of their accounts, provided
that two standards were met.\12\ The first standard required that the
aggregate of the actual funds for the fully-funded accounts be at least
ten percent of the aggregate of the nominal account sizes of the
accounts included in the program. The second standard required that the
gross trading profit ratio for the subset be ``materially the same'' as
the gross trading profit ratio for the aggregate.\13\ In other words,
the performance of the subset had to be, in fact, representative of the
performance of the aggregate, considered on the basis of the nominal
account sizes.
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\12\ ``Fully-funded'' refers to an account where the amount of
Actual Funds equals the nominal account size.
\13\ Advisory 93-13 included a specific definition of
``materially the same'' in the context of comparing two percentages,
depending on the individual size of the two percentages (i.e., 5
percent or less, between 5 percent and 10 percent, or 10 percent or
more) and the difference between the two percentages. See 58 FR at
8229.
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For example, if the CTA had 15 accounts, three of which were fully
funded, the CTA could treat the rate of return of the three fully-
funded accounts as representative of all 15 accounts as long as the two
tests were met. Thus, if all 15 accounts had nominal account sizes of
$100,000, the first standard would be met by the three fully-funded
accounts--i.e., $300,000/$1,500,000 is twenty percent, which exceeds
the ten percent minimum. This test could also be met by one
sufficiently large fully-funded account. If each of the 15 accounts
experienced gross profits of $10,000, the gross trading profits ratio
of the subset would be the same as the gross trading profits ratio of
the aggregate, meeting the second test. Advisory 93-13 explicitly
permitted a number of adjustments and exceptions to these two
standards. For example, an account could use the fully-funded subset
method despite failures to meet the ten percent test ``for a limited
number of periods.''
Advisory 93-13 ameliorated disclosure problems for those CTAs that
had sufficiently fully-funded accounts to meet the ten percent test.
Commission staff nonetheless have increasingly encountered
circumstances where CTAs have lacked (or lost) sufficient fully-funded
accounts, but where disclosure based on actual funds levels would be
misleading or confusing.
2. Proposed Changes to Commission Regulation 4.35(a)(6)(i) To Adopt
Nominal Account Size as the Denominator in the Rate of Return
Calculation
Existing Commission Regulation 4.35(a)(6)(i) requires that, in
presenting past performance to prospective participants, the rate of
return for a period be calculated by dividing net performance by the
beginning net asset value. The proposed amendment to Regulation
4.35(a)(6)(i) would require that the rate of return be computed by
dividing net performance by the nominal account size at the beginning
of the period.\14\ It is the proposed change in the denominator of the
rate of return computation--from net asset value to nominal account
size--that underlies the framework for performance presentation set
forth in the rule proposal.
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\14\ Additional changes to Rule 4.35(a)(6)(i)(A)-(F) have been
proposed to accommodate the use of nominal account size. These
changes will be discussed further below.
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The Commission recognizes that each of the methods that has been
used or proposed-the actual funds method, the fully-funded subset
method, and the nominal account size method--has flaws. For example,
under the actual funds method, two accounts with the same nominal
account size, which hold the same market positions and number of
contracts, and which experience the same gains or losses, would show
different performance if the clients choose to fund their accounts
differently.\15\ Further, the CTA's presentation of its past
performance for accounts in the same trading program could combine, in
the same actual funds-based performance table, accounts with vastly
different amounts of actual funds in relation to their nominal
size.\16\ The resulting composite presentation would blend the results
of these accounts into a rate of return that would not be
representative of any client's actual results. Some might argue that if
the actual funds-based returns of these varyingly funded accounts
differed materially from each other, their performance should be
presented in separate tables.\17\ This could result in numerous
performance tables for each of the CTA's programs, overwhelming clients
with excessive amounts of data and severely impeding the usefulness of
the performance disclosure.
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\15\ For example, Client A and Client B each have a nominal
account size of $100,000. The CTA treats the two accounts
identically, trading two S&P 500 futures contracts for each account.
Each account experiences a $10,000 profit. Client A deposits $25,000
in actual funds, while Client B fully funds the account with
$100,000. Using the actual funds method, Client A's rate of return
would be 40%, and Client B's rate of return would be 10%, even
though each client has the same nominal account size, has been
traded identically, and has received the same dollar amount in
profits.
\16\ In practice, prior to the issuance of Advisory 93-13,
Division of Trading and Markets staff interpreted the actual funds
method to require one composite table that was based solely on
actual funds, and to permit a supplemental table including
``notional funds'' (57 FR 53457, 53459 (November 10, 1992). This
interpretation appears to have been based on provisions regarding
retroactive application of Advisory 87-2, as described in an
Addendum to CFTC Advisory 87-2 ([1986-87 Transfer Binder] Comm. Fut.
L. Rep. (CCH) [para] 23,759 (August 12, 1987)).
\17\ Rule 4.35(a)(3)(ii) specifies that accounts whose rates of
return differ materially from each other may not be presented in the
same composite.
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The fully-funded subset method has turned out to be unworkable for
a number of reasons. The primary reason is that many CTAs lack fully-
funded accounts. Although Advisory 93-13 allows for limited periods
during which the fully-funded subset requirement is not met, this
allowance is predicated on the anticipated resumption of the fully-
funded subset in the near future. The Division has received numerous
questions over the years from CTAs who have qualified for the fully-
funded subset method for a period of time, but due to the closing of
fully-funded accounts and inability to obtain new fully-funded
accounts, cannot continue to use the fully-funded subset method.
Further, in recent years, the use of ``master accounts'' by
commodity pools and clients who allocate to multiple CTAs has greatly
increased. A master account is a central account in which a client
deposits funds with the FCM to support trading done by several CTAs.
Each of the CTAs is given trading authority for a sub-account, which
will reflect the positions implemented by that CTA, and profits and
losses on these positions, but to which no funds will be deposited. The
margin requirements for these positions will be met by funds maintained
in the master account. Although the CTA will know the nominal account
size, the actual funds reported to the CTA will include only the value
of the positions held in the sub-account (which could, in fact, be a
negative amount due to unrealized losses). While in the past staff have
permitted the allocation of funds in a master account to various CTAs
to be computed and reported pursuant to a Liquid Asset Allocation
(``LAA'') method,\18\ LAA methods have not proven to be workable for
the majority of CPOs and other clients with master accounts. Further,
it is unclear that such
[[Page 12004]]
allocation provides insight into the return based on ``actual'' funds.
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\18\ See CFTC Interpretative Letter 88-1, ``Application of
Division of Trading and Markets Advisory 87-2,'' [1987-1990 Transfer
Binder] Comm. Fut. L. Rep. (CCH) [para]24058 at 34639-40 (December
16, 1987).
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3. Objections to the Nominal Account Size Method Addressed
Concerns have been raised that CTAs might manipulate their nominal
account sizes.\19\ A CTA that can establish nominal account sizes
without being required to find customers willing to fully fund accounts
at such sizes might be unrestrained in setting the nominal account
size, and thus could minimize the apparent size of losses and smooth
the apparent volatility of its trading over time. Increasing the
nominal account size to minimize the apparent size of losses, however,
will unavoidably have the effect of minimizing the apparent size of
gains. CTAs will thus be faced with countervailing incentives. Some
have noted a converse problem posed by the existing rules: futures and
derivatives positions can be taken by depositing very small amounts of
actual funds for margin, relative to the value of the contract.
Positive rates of return computed on the basis of a relatively small
amount of actual funds in accounts whose level of trading is based on a
much greater nominal account size would be magnified and could provide
a potentially misleading measure of the CTA's success. As NFA's comment
letter on the earlier rule amendment proposal observed, in its
experience, ``* * * unwary customers are more likely to be lured into
the futures markets by allusions to large profits than by information
implying that futures trading is a conservative investment.'' The
Commission's own experience in this area has been similar, and it has
no basis to believe that this proposal creates any additional
incentives for CTAs to set unreasonable nominal account sizes.
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\19\ See, e.g., ``Proposed Rule Could Help Mask Commodity
Trading Volatility,'' New York Times, September 2, 1999; and
``Commodity-Adviser Reporting Rule May Change,'' Wall Street
Journal, September 7, 1999.
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Some have stated that using nominal account size to compute rates
of return would create an appearance of lowered volatility and that
disclosure of volatility experienced by program participants would be
undermined if nominal account size were used to compute rates of
return. But the rules proposed in this release are no more likely to
mask volatility than the fully-funded subset method permitted since
1993. The funding level--full or partial--chosen by past participants
neither helps nor harms prospective participants who will be receiving
past performance data based on nominal account size. A prospective
participant who chooses to partially fund will experience volatility
magnified by his or her partial funding level, and will not be helped
by the fact that other participants chose to fully fund in the past.
Conversely, a prospective participant who chooses to fully fund will
experience volatility corresponding to the nominal account size, and
will not be harmed by the fact that other participants chose to
partially fund in the past. Moreover, the performance table will
contain a pointed numerical example of the effect of partial funding on
volatility in the context of worst monthly and peak-to-valley draw-
downs. This example-based either on the lowest actual funding level or
a straight 20% funding level--will demonstrate the enhanced volatility
of partially funded accounts in a form calculated to draw the
participant's attention.
Investors should consider not only the ``cash they must put up''
initially, but the losses to which they are exposed. In this context,
participation in managed futures accounts is far different from
investment in stocks, real estate, or even commodity pools. As has been
noted: ``Commodity trading intrinsically involves leverage, the only
purchase is a futures contract (not the actual asset) and the amount of
cash required is artificially determined by exchange rules, broker
policies, CTA negotiated agreements and regulatory requirements and can
change day by day.'' \20\
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\20\ Arthur F. Bell, Jr. & Associates commenting on the earlier
rule amendment proposal.
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Investments in stock, real estate, or collective investment
vehicles such as mutual funds or commodity pools can be quantified in
advance, even if purchased on margin or through other borrowing. An
investor can purchase 100 shares of Example Co., Inc. (or Example Fund,
Inc.) at $50 a share for $5,000. Even if these shares are purchased on
margin, $5,000 is generally the limit of the loss to which the investor
is exposed.\21\ This relative certainty is absent in the context of
futures. A managed futures account participant who enters into, for
example, a stock index futures contract gains (or loses) the change in
value of the collection of stocks. The participant must post margin,
but the margin does not represent the limit of the participant's
liability. If the participant's losses exceed the initial margin, the
participant will owe the excess. Commission Rule 4.34(b) requires that
CTAs disclose these facts to prospective clients, and a CTA which
encouraged participants to think of the ``cash they have put up'' as
the limit of their losses could run afoul of Section 4o of the
Commodity Exchange Act (the ``Act'').\22\
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\21\ Transaction fees and interest are being ignored for the
purposes of these examples.
\22\ 7 U.S.C. 6o (2000).
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To be sure, the Commission has observed that there is no standard
among CTAs for the setting of nominal account sizes.\23\ The Commission
does not intend to impose a standard for the setting of nominal account
sizes on CTAs. The proposed rule does require that the CTA disclose the
factors it considers in determining the level of trading for a given
nominal account size in the offered trading program and an explanation
of how those factors are applied. Moreover, adopting nominal account
size as the denominator for the rate of return calculation would
provide a uniform basis for all CTAs to present rate of return, which
does not exist under the reporting scheme that has been in effect since
the adoption of Advisory 93-13. Use of nominal account size would
permit a much more meaningful comparison of the performance results of
CTAs.
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\23\ See 63 FR 33297 (June 18, 1998).
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After consideration of the benefits and drawbacks of each of these
methods of calculating CTAs' rates of return, the Commission is
proposing the nominal account size method, coupled with a framework of
documentation and disclosure requirements, as the method that best
reflects the reality of how managed accounts are traded, including
information regarding volatility and draw-downs. As discussed more
fully below, the existence of a written agreement that documents the
nominal account size in advance of the CTA's trading for the account is
a critical component of the performance calculation and reporting
scheme the Commission is proposing.
B. Documentation of Nominal Account Size
The proposed rules would add new paragraph (c) to Rule 4.33 to
require documentation of the nominal account size agreed upon by the
CTA and client, as well as other terms applicable to the CTA's trading
for the client's account. This provision would require that the CTA
execute a written agreement with each client that specifies: The
nominal account size; the name or description of the trading program in
which the client is participating; the basis for the computation of
fees; how additions or withdrawals of actual funds, or profits and
losses will affect each of (a) the nominal account size and (b) the
computation of fees; and whether the client will fully or partially
fund the
[[Page 12005]]
account. The requirement that the nominal account size must be
documented in advance of the CTA's trading for the client's account
will also minimize the possibility that CTAs will manipulate their
returns to appear either less volatile or more positive by frequent
adjustment of their nominal account sizes, particularly since any
revision to the nominal account size must be documented in a new
agreement, or an addendum to the existing agreement, signed by the
client.
The Commission believes that documentation of the agreement between
CTAs and their clients is important, even if all the CTA's client
accounts are fully-funded, and therefore the proposed requirements of
Rule 4.33(c) would apply to CTAs whether or not they accept partially
funded accounts. As the proposed rule indicates, CTAs would not need to
use a separate agreement to respond to the requirements specified in
Rule 4.33(c), but could incorporate the requirements into their
existing client agreements.
In addition, Rule 4.33(c) would require that changes to nominal
account size, other than those explicitly provided for in the existing
agreement (e.g., the effect of gains/losses), must be in writing, must
be signed by the client, and must explicitly indicate the current date,
the change in the nominal account size and the effective date of that
change.\24\ This requirement could be met by a simple one-sentence note
from the client requesting the change in nominal account size and
including the dollar amount of the new nominal account size, the
effective date of the change, the signature and typed or printed name
of the client, and the date the request was signed.\25\
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\24\ The effective date would be on or after the date that the
change is made.
\25\ Commission Rule 1.4 permits use of electronic signatures
with respect to compliance with Commission rules that require a
document to be signed by a customer, participant or client. An
electronic signature could therefore be used for the agreement
required by Rule 4.33(c), in accordance with the provisions of Rule
1.4 (i.e., that the electronic signature complies with applicable
Federal laws and other Commission rules, and that the CTA must adopt
and utilize reasonable safeguards regarding the use of electronic
signatures).
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C. Changes to Definitions
The Commission proposed revisions to Rule 4.10(l) to accommodate
use of nominal account size as the denominator in the calculation of
the peak-to-valley draw-down figures.\26\ Additional changes are being
proposed to codify definitions of nominal account size (Rule 4.10(m)),
actual funds (Rule 4.10(n)), partially-funded account (Rule 4.10(o))
and most recent five years (4.10(p)).
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\26\ Rule 4.10(k) defines ``draw-down'' as ``losses experienced
by a pool or account over a specified period.'' Since the definition
in Rule 4.10(k) does not refer to a method for computing such
losses, no revision to this definition would be necessary.
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The Commission wishes to make clear that Advisories 87-2 and 93-13,
as well as Interpretative Letter 88-1, would be, on a prospective
basis, superseded in their entirety by the proposed rules or any final
rules resulting from this rulemaking. Questions have been raised about
the continuing applicability of the quantitative materiality standard
that was established in Advisory 93-13 to determine whether a CTA's
accounts qualified for use of the fully-funded subset method. Although
Advisory 93-13 clearly stated that the standard was intended to be
applicable only in the context of the Advisory, the Commission
understands that these standards have come to be relied on more broadly
in ascertaining compliance with composite performance requirements of
Rule 4.35(a)(3). The Commission would accept those standards as
guidance, but not to the exclusion of other approaches that may fall
outside the threshold of Advisory 93-13. Registrants should continue to
consider all relevant facts and circumstances in making determinations
regarding materiality.
D. Disclosure of Actual Funding Levels and Funds Under Management
The Commission believes that it would be misleading to describe
``notional funds,'' which the client has chosen not to place in an
account over which the CTA has trading authority, as ``funds under
management.'' The proposed revisions to Rule 4.35(a)(1)(iv), therefore,
would clarify that the disclosure of funds under management must
reflect only the actual funds committed to the CTA's trading program
rather than the aggregate of nominal account sizes.
The Commission's proposed adoption of nominal account size for
purposes of computing the CTA's trading program rate of return is not
intended to eliminate the distinction between actual funds and nominal
account size. As we have noted before, nominal account size is not a
commitment of actual funds to the CTA's control, nor does it represent
the maximum amount of the client's potential losses or of the client's
obligations to the FCM. The Commission continues to believe that
knowledge of the amount of funds that a CTA's clients have been willing
to entrust to the control of the CTA, or the fact that the CTA does not
possess such information, may be considered valuable by prospective
clients. In addition, CTAs would not be precluded from disclosing the
aggregate of nominal account sizes, and in fact may choose to present
such information in their performance capsules adjacent to the
disclosure of actual funds under management (See proposed Rule
4.35(a)(1)(ix)(D)). Therefore, the Commission is proposing revisions to
Rule 4.35(a)(1)(iv).
To accommodate those situations where CTAs do not have access to
information regarding clients' actual funds, proposed Rule
4.35(a)(1)(iv) would permit a CTA simply to make a statement of the
fact that it does not have sufficient information regarding the funding
of its clients' accounts to determine the aggregate of actual funds
committed to its programs. Cases involving the use of master accounts,
or other funding arrangements between the client and FCM, that preclude
the CTA from having access to information regarding the client's actual
funds, might lead CTAs to state that they do not know the amount of
actual funds. The representation by the CTA of its lack of knowledge of
this amount will provide clients with valuable information regarding
the extent to which they may rely on that factor. The CTA would
continue to be required to maintain the documentation on which its
performance presentation is based \27\ and such documentation should be
sufficient to support the information in the performance capsule
regarding the disclosure, if any, of actual funds under management.
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\27\ See Rules 4.33(a) and 4.35(a)(6)(ii).
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E. Disclosures Regarding Partial Funding of Accounts
Proposed Rule 4.34(p) would require disclosure to prospective
clients of material information concerning the practice of partially
funding an account and the factors considered by the CTA in determining
the trading level for a given nominal account size. The discussion
would be required to include: (1) How the management fees would be
computed, expressed as a percentage of the nominal account size, and an
explanation of the effect of partially funding an account on the
management fees as a percentage of actual funds; (2) an estimated range
of the commissions generally charged to an account expressed as a
percentage of the nominal account size and an explanation of the effect
of partially funding an account on the commissions as a percentage of
actual funds; (3) a statement that partial funding increases leverage,
that leverage will magnify both
[[Page 12006]]
positive and negative rates of return, and that the greater the
disparity between the nominal account size and the amount deposited,
maintained or made accessible to the FCM, the greater the likelihood
and frequency of margin calls, and the greater the size of margin calls
as a percentage of the amount of actual funds committed to the
commodity trading advisor's program; and (4) a description of the
factors considered by the CTA in determining the level of trading for a
given nominal account size in the offered trading program and an
explanation of how those factors are applied.
F. Disclosures Concerning Draw-down
1. Disclosure of Draw-Down at the Lowest Funding Level
Proposed Rule 4.35(a)(1)(ix)(A) would require CTAs who accept
partially-funded accounts to present draw-down figures computed on the
basis of the actual funds committed to the CTA's program by the client
with the lowest ratio of actual funds to nominal account size in the
trading program.\28\ If the CTA did not have sufficient information
regarding the funding level of its client accounts, or if the lowest
ratio was zero, the draw-down information would be presented at a
funding level of 20 percent. These additional draw-down figures would
be presented adjacent to the worst monthly and peak-to-valley draw-down
percentages based on the aggregate nominal account sizes.
---------------------------------------------------------------------------
\28\ For example, if the lowest funding level is 25 percent and
the greatest monthly draw-down is 15 percent, the draw-down shown on
the basis of actual funding would be 60 percent (15 percent / 25
percent).
---------------------------------------------------------------------------
If a client funds its account traded by the CTA at a level of
actual funds that is less than the nominal account size, then gains or
losses will represent a larger percentage of the client's actual funds.
Further, the smaller the amount of actual funds is in relation to the
nominal account size, the faster losses will reduce the amount of
actual funds, increasing both the likelihood of margin calls and the
amount of additional margin that may be required. The purpose of
disclosing draw-downs at the least-funded level is to highlight these
effects to prospective clients who may be considering partially funding
their accounts with the CTA. The option of using a 20% level is
intended to accommodate situations where the CTA does not have
sufficient information regarding the funding level of its client
accounts, or where the lowest funding ratio is zero, precluding
calculation of a meaningful number.
Proposed Rule 4.35(a)(1)(ix)(A) would require the addition of only
two percentage draw-down figures, adjacent to the worst monthly and
peak-to-valley draw-down percentages for the aggregate nominal account
sizes. This would not amount to data overload. Further, since the
intent of the disclosure is to convey the impact of draw-downs on the
actual funds in partially-funded accounts, use of the 20% funding level
where CTAs do not have any accounts with actual funding or do not know
the amount of actual funds would enable their performance capsules to
convey information about the increased impact of draw-downs on the
actual funds in partially-funded accounts.
2. Use of Composite Draw-down
Proposed Rules 4.35(a)(1)(v) and (vi) would require that the worst
monthly and peak-to-valley draw-down amounts be based on the aggregate
of nominal account sizes, i.e., the composite of accounts, rather than
the worst individual account.\29\ A variety of factors, including, but
not limited to, differences due to trade execution, fees, commissions,
and the timing of opening or closing accounts, may have an impact on
the returns for individual accounts. The effect of these factors must
be considered by the CTA in the development of its composite
performance tables and any material differences among the accounts in
the composite must be discussed.\30\ For a performance table that
complies with the Commission's rules on use of composites, disclosure
of draw-down information on a composite basis would not be misleading.
However, CTAs would remain subject to the requirement of Rule 4.34(o)
to disclose all material information to existing or prospective clients
even if such information is not specifically required by these
regulations.
---------------------------------------------------------------------------
\29\ Current Rule 4.10(k) defines the term ``Draw-down as
``losses experienced by a pool or account over a specified period:
Rule 4.10(l) defines the term ``Worst peak-to-valley draw-down'' for
a pool, account or trading program. In its adopting release for the
most recent revisions to the Part 4 rules, the Commission noted that
`` . . . the draw-down figures in a composite in a CTA Disclosure
Documents are the worst experienced by any one of the accounts
included in the composite'' (emphasis added). 60 FR 38146, 38162
(July 25, 1995).
\30\ Rule 4.35(a)(3) states:
(i) Unless such presentation would be misleading, the
performance of accounts traded pursuant to the same trading program
may be presented in composite form on a program-by-program basis * *
*.
(ii) Accounts that differ materially with respect to rate of
return may not be presented in the same composite.
(iii) The commodity trading advisor must discuss all material
differences among the accounts included in a composite.
---------------------------------------------------------------------------
G. Treatment of Interest Income
The proposed definition of net performance in Rules 4.10(l)(3) and
4.35(a)(6)(i)(B)\31\ would permit CTAs to include interest income on
funds deposited in the client's commodity interest account directed by
the CTA, as well as any other income on positions held as part of the
CTA's program. The fact that trading fees are charged against the CTA's
performance, even where the commission rate is negotiated by the client
and the FCM, supports the inclusion of interest earned at the FCM in
the CTA's performance to maintain parity. In addition, interest is, in
a real sense, part of the return on the funds. Regardless of the amount
of actual funds a client deposits with the FCM, whether influenced by
the CTA's trading strategies, the FCM's credit determination, or the
client's wishes, income on these funds is part of the account's
performance. Further, the computation of net performance under the
regulations that have been in effect since 1981 has included interest
income. The components of net performance--the numerator of the rate of
return computation--will not be affected by the change of the
denominator from net asset value to nominal account size. It is the
adoption of nominal account size, rather than net asset value, as the
basis for performance calculation that will require changes to the
definition of net performance in proposed Rules 4.10(l)(3) and
4.35(a)(6)(i)(B).
---------------------------------------------------------------------------
\31\ Although net performance is defined in the context of both
Rule 4.10(l), with respect to computation of worst peak-to-valley
draw-down, and Rule 4.35(a)(6)(i)(B), with respect to calculation of
performance information, the definitions are the same.
---------------------------------------------------------------------------
The proposed rule also would provide that no interest income may be
imputed with respect to nominal account sizes or otherwise computed on
a pro-forma basis. The Commission notes that the reference in the
proposed rules to ``other income'' on instruments held as part of the
CTA's program is intended to apply to programs in which the CTA may
direct the trading of instruments, such as stocks or bonds, on which
income is earned.\32\ While this provision may not be applicable to
most CTAs, it is intended to permit those CTAs who direct the trading
of income-producing
[[Page 12007]]
instruments as part of their trading programs to reflect the
performance of those instruments in their trading results. In the
disclosure document review process and compliance audits, close
attention would be paid to the description of the trading program and
other documentation regarding the CTA's direction of income-producing
instruments included in its performance record.
---------------------------------------------------------------------------
\32\ While this provision acknowledges that CTAs may offer
programs that trade instruments in addition to futures contracts, it
in no way implies that such activity may be conducted by CTAs
outside of the appropriate registration or other regulatory
requirements of agencies with jurisdiction over those instruments.
---------------------------------------------------------------------------
H. Range of Rates of Return for Closed Accounts
The Commission proposes to revise Rule 4.35(a)(1)(viii) to require
that the performance capsule for the offered program include, in
addition to the number of accounts closed with profits and the number
closed with losses, the range of rates of return for the accounts
closed with net lifetime profits and accounts closed with net lifetime
losses, during the five-year period. The Commission believes that
disclosing the range of rates of return for closed accounts in the
offered program provides important summary information on the variation
in returns experienced by individual clients and will be useful to
prospective clients considering participation in the CTA's program.
Because the draw-down information under the revised rules will be
presented on a composite basis, presentation of the range of rates of
return for closed accounts provides valuable information on the results
experienced by individual clients.
The Commission notes that under the proposed rule amendments, both
the numbers of accounts closed with positive versus negative rates of
return, as well as the ranges of rates of return for accounts in each
category, must be disclosed only for those accounts that both opened
and closed within the required five-year and year-to-date time period.
The Commission does not believe that this change will diminish the
disclosure of material information to prospective clients, because of
the tendency of clients to quickly close accounts that experience large
losses. Accounts that experienced strongly negative returns before the
five-year time period are likely to have been closed before the end of
that time period, and losses experienced as a result of the offered
program during the five-year period are likely to have been experienced
by an account that both opened and closed during that period. The
Commission wishes to make clear that any additional information that
the CTA believes is necessary to explain the circumstances affecting
the ranges of returns presented in the performance capsule may be
provided, pursuant to existing rules regarding supplemental disclosures
and material information.\33\
---------------------------------------------------------------------------
\33\ See, Commission Rules 4.34(n) and 4.34(o).
---------------------------------------------------------------------------
I. Treatment of Additions and Withdrawals in Computing Rate of Return
In proposing to amend Rule 4.35(a)(6)(i)(B), the Commission notes
that CTAs would be permitted to choose, for their rate of return
computation, one of the following three methods: (1) Net performance
divided by beginning nominal account size; (2) daily compounded rate of
return; or (3) net performance divided by the average weighted nominal
account sizes for the month. These proposed changes would incorporate
alternative methods of computing rate of return to account for
intramonth additions and withdrawals, as permitted by the CFTC's 1991
Advisory.\34\ The Commission is not proposing to include the Only
Accounts Traded Method as an option CTAs may choose prospectively due
to concerns that it allows for accounts to be excluded entirely from
the rate of return computation. The Commission will, however, carefully
consider proposals regarding any alternative method of addressing the
effect of additions and withdrawals on the rate of return computation,
whether as part of this rulemaking proposal or otherwise in the future.
---------------------------------------------------------------------------
\34\ CFTC Advisory, ``Adjustments for Additions and Withdrawals
to Computation of Rate of Return in Performance Records of Commodity
Pool Operators and Commodity Trading Advisors,'' 56 FR 8109
(February 27, 1991).
---------------------------------------------------------------------------
The rule changes proposed herein would supersede applicability to
CTAs of the CFTC's 1991 Advisory.\35\ CTA performance computed in
accordance with any of the alternative methods described in the 1991
Advisory for periods prior to the date upon which the rule changes
proposed herein become effective, however, would not need to be
revised. Because commodity pool performance may only be reported on the
basis of actual funds, applicability of the 1991 Advisory to CPOs
reporting commodity pool performance would be unchanged.
---------------------------------------------------------------------------
\35\ CFTC Advisory, ``Adjustments for Additions and Withdrawals
to Computation of Rate of Return in Performance Records of Commodity
Pool Operators and Commodity Trading Advisors,'' 56 FR 8109
(February 27, 1991).
---------------------------------------------------------------------------
J. Disclosure of CTA Performance in CPO Disclosure Documents
The Commission is proposing changes to the presentation of CTA
performance in CPO disclosure documents primarily to conform such
presentation with the proposed revisions to Rule 4.35(a)(1). The
Commission emphasizes that narrative disclosure of the pool's
allocations to its CTAs, as well as the use of leverage in determining
such allocations, continues to be required pursuant to existing Rules
4.24(g) and 4.24(h).
III. Transitional Provisions
The Commission proposes to require CTAs and CPOs to comply with the
revisions proposed herein, including the requirement to obtain the
documentation required by new Rule 4.33(c) for both new and existing
clients, by no later than the beginning of the calendar quarter that is
at least 90 days after the date of publication of the final rules. The
Commission seeks comment on any difficulties anticipated in complying
with these proposed requirements by that date. CTAs and CPOs would be
permitted to adopt these changes immediately upon the effective date of
the final rules as adopted.
IV. Request for Comments Regarding a Core Principle Alternative
The Commission has received a number of requests from the managed
funds industry that Commission policy pertaining to CTA disclosure of
past performance to prospective clients be made consistent with the
approach undertaken in the securities industry.\36\ Under Federal
securities laws there are no rules that mandate the manner in which
investment advisers disclose past performance. Generally, investment
advisers may present past performance in any manner that does not run
afoul of general anti-fraud provisions.\37\ It has been suggested that
the Commission adopt a core principle in order to achieve parity with
applicable securities laws and regulations as they relate to the
disclosure of past performance made by CTAs to prospective clients.\38\
Such a core principle would permit CTAs to present past performance to
prospective clients in any manner they choose so long as such
information is offered in a manner that is factual and balanced and is
not misleading or fraudulent.
---------------------------------------------------------------------------
\36\ See Transcript from CFTC Roundtable on Managed Funds Issues
<http://www.cftc.gov/files/opa/press02/
oparoundtable091902.pdf
.
\37\ See the Investment Advisers Act of 1940 section 206(4) (15
U.S.C. 80b-6(4)) and Securities and Exchange Commission Rule
275.206(4)-1(a)(5) (17 CFR 275.206(4)-(1)(a)(5)). For a more
complete discussion regarding the use of past performance by
investment advisers for soliciting clients, see Robert J. Zutz,
Compliance Review, Schwab Institutional, Vol. 10, Issue 8, Aug.
2001.
\38\ See, e.g., Testimony of George Crapple at the CFTC
Roundtable on Managed Funds Issues. Transcript from CFTC Roundtable
on Managed Funds Issues at 84.
---------------------------------------------------------------------------
Consistent with the intention of the Commodity Futures
Modernization Act
[[Page 12008]]
of 2000,\39\ the Commission is requesting comment on the desirability
of implementing a core principle that would replace the current rules,
and ameliorate the need for the amendments proposed herein, regarding
the manner in which a CTA presents past performance to prospective
clients. In particular, the Commission is requesting comments on the
following questions:
---------------------------------------------------------------------------
\39\ Pub. L. No. 106-554, 114 Stat. 2763 (2000) (codified as
amended in scattered sections of 7 U.S.C.). See, e.g., section 125
(requiring the Commission to conduct a study of the Act and the
Commission's rules and orders governing the conduct of registrants
under the Act, identifying, among other things, Commission rules
that may be replaced by core principles).
(1) What form should such core principle take? Commenters are
requested to provide specific language for the core principle.
(2) Should certain presentations of past performance be
specifically prohibited or limited?
(3) Should the rules proposed herein serve as a safe harbor in
the event the Commission determines to adopt a core principle
approach, and/or should the Commission develop more general guidance
concerning compliance with the core principle?
(4) Would the implementation of a core principle approach lead
to more or less meaningful and useful information being provided to
prospective clients?
(5) Is the experience of the securities industry with the use of
a core principle approach for performance presentation relevant to
the use of such an approach in the futures industry?
In offering the above questions, the Commission does not intend to
limit the scope of the discussion regarding the alternative of a core
principle. These questions are meant only as a starting point and the
Commission encourages the submission of comments that address these, as
well as any other pertinent questions.
V. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (``RFA''), 5 U.S.C. 601-611 (1994),
requires that agencies, in proposing rules, consider the impact of
those rules on small businesses. The Commission has previously
established certain definitions of ``small entities'' to be used by the
Commission in evaluating the impact of its rules on such entities in
accordance with the RFA.\40\ The Commission previously has determined
that registered CPOs are not small entities for the purpose of the
RFA.\41\ With respect to CTAs, the Commission has stated that it would
evaluate within the context of a particular rule proposal whether all
or some affected CTAs would be considered to be small entities and, if
so, the economic impact on them of any rule.\42\ In this regard, the
Commission notes that the rule revisions adopted herein create some
changes to the content of the documentation and disclosure requirements
for CTAs, but do not increase such requirements, and, in fact, are
expected ultimately to ease the computational and recordkeeping
requirements for CTAs who manage partially-funded client accounts. The
Commission has previously determined that the disclosure requirements
governing this category of registrant will not have a significant
economic impact on a substantial number of small entities.\43\
Therefore, the Chairman, on behalf of the Commission, hereby certifies,
pursuant to 5 U.S.C. 605(b), that these regulations will not have a
significant economic impact on a substantial number of small entities.
---------------------------------------------------------------------------
\40\ 47 FR 18618-18621 (April 30, 1982).
\41\ 47 FR 18619-18620.
\42\ 47 FR 18618-18620.
\43\ See 60 FR 38146, 38181 (July 25, 1995) and 48 FR 35248
(August 3, 1983).
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B. Paperwork Reduction Act
These rules [Sections 4.31 and 4.33] contain information collection
requirements. As required by the Paperwork Reduction Act of 1995,\44\
the Commission has submitted a copy of this rule to the Office of
Management and Budget (OMB) for its review.\45\
---------------------------------------------------------------------------
\44\ Pub. L. 104-13 (May 13, 1995).
\45\ 44 U.S.C. 3504(h).
---------------------------------------------------------------------------
Collection of Information
Rules relating to the operations and activities of Commodity Pool
Operators and Commodity Trading Advisors and to monthly reporting by
Futures Commission Merchants, OMB control number 3038-0005.
The proposed amendments would not affect the paperwork burdens
associated with the above collections of information, which have
previously been approved by OMB in connection with the Commission's
previous submission of the proposed rules.
Copies of the information collection submission to OMB are
available from the CFTC Clearance Officer, 1155 21st Street, NW.,
Washington, DC 20581, (202) 418-5160.
Persons wishing to comment on the information collection
requirements that would be required by these proposed rules should
contact the Office of Information and Regulatory Affairs, Office of
Management and Budget, Room 10235, New Executive Office Building,
Washington, DC 20503, Attn: Desk Officer for the Commodity Futures
Trading Commission.
The Commission considers comments by the public on this proposed
collection of information in--
Evaluating whether the proposed collection of information is
necessary for the proper performance of the functions of the
Commission, including whether the information will have a practical
use;
Evaluating the accuracy of the Commission's estimate of the
burden of the proposed collection of information including the
validity of the methodology and assumptions used;
Enhancing the quality, utility, and clarity of the information
to be collected; and
Minimizing the burden of the collection of the information on
those who are to respond, including through the use of appropriate
automated, electronic, mechanical or other technological collection
techniques or other forms of information technology, e.g.,
permitting electronic submissions of responses.
OMB is required to make a decision concerning the collection of
information contained in these proposed regulations between 30 and 60
days after publication of this document in the Federal Register.
Therefore, a comment to OMB is best assured of having its full effect
if OMB receives it within 30 days of publication. This does not affect
the deadline for the public to comment to the Commission on the
proposed regulations.
Copies of the information collection submission to OMB are
available from the CFTC Clearance Officer, 1155 21st Street, NW.,
Washington, DC 20581 (202) 418-5160.
List of Subjects in 17 CFR Part 4
Brokers, Commodity futures, Commodity pool operators, Commodity
trading advisors.
In consideration of the foregoing and pursuant to the authority
contained in the Commodity Exchange Act and, in particular, sections
1a(4), 4k, 4l, 4m, 4n, 4o and 8a, 7 U.S.C. 1a(4), 6k, 6l, 6m, 6n, 6o,
and 12a, the Commission hereby proposes to amend Chapter I of the Code
of Federal Regulations as follows:
PART 4--COMMODITY POOL OPERATORS AND COMMODITY TRADING ADVISORS
1. The authority citation for part 4 continues to read as follows:
Authority : 7 U.S.C. 1a, 2, 4, 6b, 6c, 6l, 6m, 6n, 6o, 12a and
23.
2. Section 4.10 is proposed to be amended by revising paragraph (l)
and adding paragraphs (m), (n), (o) and (p) to read as follows:
Sec. 4.10 Definitions.
* * * * *
[[Page 12009]]
(l) Worst peak-to-valley draw-down means:
(1) For a commodity pool, the greatest cumulative percentage
decline in month-end net asset value due to losses sustained during any
period in which the initial month-end net asset value is not equaled or
exceeded by a subsequent month-end net asset value. Such decline must
be expressed as a percentage of the initial month-end net asset value,
together with an indication of the months and year(s) of such decline
from the initial month-end net asset value to the lowest month-end net
asset value of such decline.
(2) For an account directed by a commodity trading advisor or for a
commodity trading advisor's trading program, the greatest negative net
performance during any period, beginning at the start of one month, and
ending at the conclusion of that month or a subsequent month. The worst
peak-to-valley draw-down must be expressed as a percentage of the
nominal account size at the beginning of the period, together with an
indication of the months and year(s) of such draw-down.
(3)(i) For purposes of paragraph (l)(2) of this section, net
performance for a period is defined as the total of:
(A) The realized gain or loss on positions closed during the
period; plus
(B) The change during the period in unrealized gain or loss; plus
(C) Interest income on funds on deposit in an account at a futures
commission merchant to margin the client account which a commodity
trading advisor directs; plus
(D) Other income earned on positions held as part of the commodity
trading advisor's program; minus
(E) Fees and expenses.
(ii) No interest or other income may be imputed with respect to
nominal account sizes or otherwise computed on a pro-forma basis.
(4) For purposes of Sec. Sec. 4.25 and 4.35, a peak-to-valley
draw-down, which began prior to the beginning of the most recent five
calendar years and continues into or ends during the most recent five
years, is deemed to have occurred during such five-calendar-year
period.
(m) Nominal account size means the account size, designated in the
written agreement specified in Sec. 4.33(c), that establishes the
client's level of trading in a commodity trading advisor's program.
(n) Actual funds means the amount of margin-qualifying assets,
either:
(1) On deposit in an account at a futures commission merchant to
margin the client account which a commodity trading advisor directs; or
(2) In another account, so long as the commodity trading advisor
has written evidence demonstrating the following:
(i) The client owns the funds;
(ii) The futures commission merchant carrying the client's account
that the commodity trading advisor directs (the ``trading account'')
has the power readily to use all, or a designated portion of, the funds
in the other account for the purpose of meeting margin requirements in
connection with the trading account, on a routine operational basis and
without advance notice to the client; and
(iii) The commodity trading advisor has ready access to information
concerning the balance in the other account available to meet margin
requirements for the trading account.
(o) Partially-funded account means a client participation in the
program of a commodity trading advisor in which the amount of actual
funds is less than the nominal account size.
(p) For purposes of Sec. Sec. 4.25 and 4.35, the term most recent
five years means:
(1) The time period beginning January 1 of the calendar year five
years prior to the date of the Disclosure Document and ending as of the
date of the Disclosure Document; or
(2) The life of the trading program, if less than five years.
3. Section 4.25(a)(1)(ii) is proposed to be amended by revising
paragraphs (a)(1)(ii)(D)(1) and (2), (a)(1)(ii)(E) and (a)(1)(ii)(F) to
read as follows:
Sec. 4.25 Performance disclosures.
(a) * * *
(1) * * *
(ii) * * *
(D)(1) The aggregate of actual funds for all of the trading
programs of the trading advisor or other person trading the account, as
of the date of the Disclosure Document or, if the commodity trading
advisor does not have sufficient information regarding the funding of
its clients' accounts to determine the aggregate of actual funds for
its programs, a statement of that fact;
(2) The aggregate of actual funds for the specified trading program
of the commodity trading advisor, as of the date of the Disclosure
Document or, if the commodity trading advisor does not have sufficient
information regarding the funding of its clients' accounts to determine
the aggregate of actual funds for the specified trading program, a
statement of that fact.
(E) The greatest monthly draw-down during the most recent five
years for the trading program specified, expressed as a percentage of
aggregate nominal account sizes, and indicating the month and year of
the draw-down.
(F) The greatest peak-to-valley draw-down during the most recent
five years for the trading program specified, expressed as a percentage
of aggregate nominal account sizes at the beginning of the period, and
indicating the month(s) and year(s) of the draw-down.
* * * * *
4. Section 4.33 is proposed to be amended by adding paragraphs (c)
and (d) to read as follows:
Sec. 4.33 Recordkeeping.
* * * * *
(c) A commodity trading advisor must obtain a written agreement
signed by each client which, at a minimum, clearly specifies:
(1) The nominal account size;
(2) The name or description of the trading program in which the
client is participating;
(3) The basis for the computation of fees;
(4) How additions or withdrawals of actual funds, profits, and
losses will each affect the nominal account size and the computation of
fees; and
(5) Whether the client will fully or partially fund the account.
(d) Any changes to nominal account size (other than changes
resulting from the factors listed in Sec. 4.33(c)(4) and documented as
required by that subsection) must be in writing, must be signed by the
client, and must explicitly indicate the current date, the new nominal
account size and the effective date of the change.
5. Section 4.34 is proposed to be amended by adding paragraph (p)
to read as follows:
Sec. 4.34 General disclosures required.
* * * * *
(p) Additional Disclosure by Commodity Trading Advisors Accepting
Partially-funded Accounts. A commodity trading advisor that accepts a
partially-funded account (as defined in Sec. 4.10(o)) must disclose:
(1) How the management fees will be computed, expressed as a
percentage of the nominal account size, and an explanation of the
effect of partially funding an account on the management fees as a
percentage of actual funds;
(2) An estimated range of the commissions generally charged to an
account expressed as a percentage of the nominal account size and an
explanation of the effect of partially funding an account on the
commissions as a percentage of actual funds;
(3) A statement that partial funding increases leverage, that
leverage will magnify both positive and negative rates of return, and
that the greater the disparity between the nominal account
[[Page 12010]]
size and the amount deposited, maintained or made accessible to the
futures commission merchant, the greater the likelihood and frequency
of margin calls, and the greater the size of margin calls as a
percentage of the amount of actual funds committed to the commodity
trading advisor's program; and
(4) A description of the factors considered by the commodity
trading advisor in determining the level of trading for a given nominal
account size in the offered trading program and an explanation of how
those factors are applied.
6. Section 4.35 is proposed to be amended by revising paragraphs
(a)(1)(iv) through (a)(1)(ix), (a)(2)(iv), (a)(6)(i)(A) through (F),
and (a)(6)(ii) to read as follows:
Sec. 4.35 Performance disclosures.
* * * * *
(a) General principles.--(1) * * *
(iv)(A) The aggregate of actual funds for all of the trading
programs of the trading advisor or other person trading the account, as
of the date of the Disclosure Document, or, if the commodity trading
advisor does not have sufficient information regarding the funding of
its clients' accounts to determine the aggregate of actual funds for
its programs, a statement of that fact;
(B) The aggregate of actual funds for the specified trading program
of the commodity trading advisor, as of the date of the Disclosure
Document, or, if the commodity trading advisor does not have sufficient
information regarding the funding of its client accounts to determine
the aggregate of actual funds for the specified trading program, a
statement of that fact.
(v) The greatest monthly draw-down during the most recent five
years for the trading program specified, expressed as a percentage of
aggregate nominal account sizes, and indicating the month and year of
the draw-down;
(vi) The greatest peak-to-valley draw-down during the most recent
five years for the trading program specified, expressed as a percentage
of aggregate nominal account sizes at the beginning of the period, and
indicating the month(s) and year(s) of the draw-down;
(vii) Subject to Sec. 4.35(a)(2) for the offered trading program,
the annual and year-to-date rate-of-return for the program specified
for each of the five most recent calendar years and year-to-date,
computed on a compounded monthly basis; and
(viii) In the case of the offered trading program:
(A)(1) The number of accounts traded pursuant to the offered
trading program that were opened and closed during the period specified
in Sec. 4.35(a)(5) with a positive net lifetime rate of return as of
the date the account was closed; and
(2) The range of rates of return for accounts that were both opened
and closed during the period specified in Sec. 4.35(a)(5) and closed
with positive net lifetime rates of return; and
(B)(1) The number of accounts traded pursuant to the offered
trading program that were opened and closed during the period specified
in Sec. 4.35(a)(5) with negative net lifetime rates of return as of
the date the account was closed; and
(2) The range of rates of return for accounts that were both opened
and closed during the period specified in Sec. 4.35(a)(5) and closed
with negative net lifetime rates of return.
(C) The net lifetime rate of return shall be calculated as the
compounded product of the monthly rates of return for each month the
account is open.
(ix) In addition to the information specified in Sec.
4.35(a)(1)(i)-(viii), where the commodity trading advisor accepts
partially-funded accounts, the performance capsule must include:
(A) A statement that rates of return are based on nominal account
size.
(B) In a column adjacent to the presentation of data based on
nominal account size, the draw-down information required by Sec.
4.35(a)(1)(v) and (vi), divided by the percentage of actual funds
committed to the commodity trading advisor's program by the client with
the lowest ratio of actual funds to nominal account size in the trading
program.
(1) If the commodity trading advisor does not have sufficient
information regarding the funding level of its client accounts to
determine the lowest ratio, or if the lowest ratio is zero, present
this information at a funding level of 20 percent.
(2) The percentage basis of the computation, i.e., the actual funds
ratio or the optional 20 percent, must be disclosed in the heading of
the column.
(C) If the commodity trading advisor elects to include the
aggregate of the nominal account sizes of the client accounts in the
trading program specified, this information must be placed adjacent to
the disclosure of actual funds under management by the commodity
trading advisor as required by Sec. 4.35(a)(1)(iv).
(2) Additional requirements with respect to the offered trading
program.
* * * * *
(iv) The commodity trading advisor must make available to
prospective and existing clients upon request a table showing the
information required to be calculated pursuant to Sec. 4.35(a)(6).
This table must be updated at least quarterly.
* * * * *
(6) Calculation of, and recordkeeping concerning, performance
information.
(i) * * *
(A) The nominal account size at the beginning of the period,
defined as the previous period's ending nominal account size;
(B)(1) The net performance for the period, which is defined as the
total of:
(i) The realized gain or loss on positions closed during the
period, plus
(ii) The change during the period in unrealized gain or loss, plus
(iii) Interest income on funds on deposit in an account at a
futures commission merchant to margin the client account which a
commodity trading advisor directs, plus
(iv) Other income earned on positions held as part of the CTA's
program, minus
(v) Fees and expenses.
(2) No interest or other income may be imputed with respect to
nominal account sizes or otherwise computed on a pro-forma basis.
(C) The nominal rate of return for the period, which must be
compounded no less frequently than monthly and which shall be
calculated by one of the following three methods, consistently applied:
(1) Computing the net performance divided by the beginning nominal
account size for each trading day in the period and compounding each
daily rate of return to determine the rate of return for the period;
(2) Dividing the net performance by the arithmetic mean of the
nominal account sizes for each trading day during the period; or,
(3) Dividing the net performance by the nominal account size at the
beginning of the period.
(D) Changes to the nominal account size during the period, pursuant
to the terms of the commodity trading advisor's agreement with the
client in accordance with Sec. 4.33(c)(4). The records should clearly
delineate the source of each change (additions or withdrawals of actual
funds, profits or losses, or otherwise).
(E) Changes to the nominal account size pursuant to the terms of
the commodity trading advisor's agreement with the client in accordance
with Sec. 4.33(c)(1). The records should clearly delineate the source
of each change (the opening or closing of accounts during the period or
changes to nominal account size specifically directed by a client in
writing). If a client and the advisor agree that a nominal account
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size be changed effective at the beginning of a period, the change
shall be reflected at the end of the prior period.
(F) The nominal account size at the end of the period, defined as
the sum of the nominal account size at the beginning of the period
[Sec. 4.35(a)(6)(i)(A)] and the changes specified in this Sec.
4.35(a)(6)(i) subparagraphs (D) and (E).
(ii) All supporting documents necessary to substantiate the
computation of such amounts must be maintained in accordance with Sec.
1.31.
* * * * *
Issued in Washington, DC on March 10, 2003 by the Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 03-6081 Filed 3-12-03; 8:45 am]
BILLING CODE 6351-01-U