February 10, 1999
Dear Commodity Pool Operator:
The Division of Trading and Markets ("Division") of the Commodity Futures Trading Commission ("Commission") is sending this letter to all registered commodity pool operators ("CPOs") to assist them and their public accountants in complying with Part 4 of the Commission's regulations under the Commodity Exchange Act ("CEAct") in connection with the preparation and filing of a pool's annual financial report.
National Futures Association ("NFA") and Commission staff reviewed more than 1,000 commodity pool annual reports for 1997. Most of the reports were accepted as filed with no further action being required. In other cases the staff sent letters to CPOs requiring either that the reports be corrected and re-filed or that certain deficiencies be remedied in 1998 filings. In order to improve the quality of the reports filed for 1998, CPOs should take special note of the deficiencies discussed below. These are the most common filing deficiencies found by staff.
In preparing for the audit of 1998 financial reports, CPOs and their accountants should review Section 4.22 of the Commission's regulations that discusses the requirements for year-end reports. They should also review the AICPA's Practice Aid, Audits of Futures Commission Merchants, Introducing Brokers, and Commodity Pools.1 Chapter 8 covers the Commission's regulations and the Division's advisories and interpretations concerning CPOs. This chapter also contains illustrations of pool financial statements and appropriate disclosures.
If a pool is operating pursuant to a claim for exemption under section 4.7 of the regulations, the annual financial report is not required to be audited, but still must be presented in accordance with generally accepted accounting principles and filed with the Commission and NFA within 90 days of the pool's fiscal year-end. The cover page of the annual report should state that it is a Rule 4.7 pool with a legend consistent with section 4.7(a)(2)(iii)(C).
I. Deficiencies in Annual Reports Filed with the Commission and NFA
For each of the topics noted below, the applicable regulation is noted. In the case of pools operating pursuant to a claim for relief based on regulations 4.7 or 4.12, the applicable regulations are shown in brackets and italicized.
1. Filing reports in a timely manner For each pool that a CPO operates, regulation 4.22(c) [4.7(a)(2)(iii) or 4.12(b)(2)(iii)] requires the CPO to provide an annual report to investors, to the CFTC (2 copies), and to NFA within 90 days of the pool's fiscal year-end. CPOs are strongly encouraged to file one additional copy of the annual report with the appropriate CFTC regional office2, which is ultimately responsible for determining whether or not a report has been filed.3 If a CPO needs an extension of time to file a pool's annual report, it should make such a request to NFA before the due date of the report and file a copy of the request with the Division's Washington headquarters office. The request must comply with the requirements of regulation 4.22(f), which are set forth in Appendix A to this letter.4 These requirements are discussed in CFTC Advisory No. 87-1 (CCH ¶23,481). Except in the case of "funds of funds," extensions are granted only upon a showing of unusual extenuating circumstances. Moreover, extensions of more than 45 days are rarely, if ever, granted.
Regulation 4.22(c) further requires that a CPO must notify the Commission by the end of January if it did not operate any commodity pools during the preceding year.
2. Disproportionate share of net income Regulation 4.22(e) requires the Statement of Income (Loss) included in the pool's annual report to "itemize...management fees, advisory fees, incentive fees, interest income and expense." CFTC Interpretative Letter No. 94-3, Special Allocations of Investment Partnership Equity (CCH ¶25,943), describes the procedures for reporting special allocations of partnership equity from limited partners to the general partner. These special allocations must be recognized in the same period as the net income or other basis of computation; classified in the income statement as either an expense or a special allocation of net income; separately reported in the statement of partnership equity; and deducted in the computation of net performance and rate-of-return information. The Interpretative Letter also applies to pools filing under Regulations 4.7 or 4.12.
Staff found that these special allocations were often only shown in the statement of changes in partners' capital or discussed in notes and were not being reported on the face of the income statement in accordance with regulation 4.22(e) and Interpretative Letter No. 94-3. To provide meaningful disclosure, the income statement of a commodity pool must show an investor the amount available to all investors, net of preferential allocations.
3. Information concerning net asset values Regulation 4.22(c)(2) requires that a pool's annual report include the following information: either the net asset value per outstanding participation unit in the pool as of the end of the current and preceding fiscal years, or the total value of each participant's interest or share in the pool as of the end of the current and preceding years. This information need not be included in the annual report for a Rule 4.7 pool if it has already been provided in a separate 4th quarter report to participants and is not required for a pool with a Rule 4.12 exemption.
Staff found that Net Asset Value information was frequently missing. Indeed, one quarter of all deficiency letters sent by staff to CPOs cited missing Net Asset Value information.
4. Oath or affirmation by CPO Regulation 4.22(h) [4.7(a)(2)(iii)(A) or 4.12(b)(iii)(A)] requires that each annual report include a signed oath or affirmation that, to the best knowledge and belief of the person signing on behalf of the CPO, the information in the report is accurate and complete. Below the signed oath or affirmation there must be typed the name of the individual signing, the capacity in which he or she is signing, the name of the CPO, and the name of the commodity pool. The person signing must be the chief executive or chief financial officer of the CPO, a general partner of the CPO, or a sole proprietor CPO.
Staff found that the oath or affirmation was frequently missing or there was no signature on the line provided for a signature. Many CPOs incorrectly believe that the oath is required only with the regulators' copy of the financial report. A signed oath, or a copy thereof, is required to be distributed with every copy of a financial report, including those to each participant or potential participant.
II. Subsequent Events
Regulation 4.22(c)(5) [4.7(a)(2)(iii)(3) or 4.12(b)(2)(iii)] states that a pool's annual report must contain appropriate footnote disclosure and further material information as may be necessary to make the required statements not misleading. The staff interprets these regulations to require that significant changes in performance between the date of the financial statements and their issuance to investors be reported in notes to the financial statements. "Subsequent Event" disclosure is also required by the Statements on Auditing Standards Nos. 1 and 12 (AU Section 560).
III. Fund of Funds Considerations
In recent years there has been an increase in the number of "fund of funds" arrangements, in which one pool ("investor pool") invests its assets in another pool ("investee pool") rather than directly in futures, options or securities. In some of these arrangements, the investor pool has invested a significant amount of its assets in one or more investee pools. The degree of investment raises financial reporting issues for these investor pools. Regulation 4.10(d)(5) defines a major investee pool as one to which the investor pool has allocated at least ten percent of its net assets.
Investor pools, like all other pools, are required by Regulation 4.22(c)(5) [4.7(a)(2)(iii)(A)(3) or 4.12(b)(2)(iii)] to include appropriate note disclosures and any other material information in each annual report.
The Division staff believes that, at a minimum, an investor pool should disclose the following information with respect to each major investee pool:
(i) name of the pool;
(ii) carrying value of the investment;
(iii) liquidity information (such as limitations on withdrawals from the investee pool); and
(iv) summary income statement information required under Regulation 4.22(e), including information on fees paid (expressed in dollars) by the investee pool to the investee pool's CPO and CTAs.
The above information should be disclosed to investor pool participants so that they are aware of the nature of their pool's investments in investee pools.
IV. Organization Costs
Organization costs are costs associated with the formation of a pool and are typically incurred before commencement of its business activities. Typical of these costs are those incurred in connection with:
(i) preparing a limited partnership agreement, operating agreement and other governing agreements for the pool;
(ii) registering and making required filings with state regulatory bodies; and
(iii) entering into contractual agreements between the pool and other parties, such as the pool's general partner or trading advisors.
In 1998, the AICPA issued Statement of Position No. 98-5, Reporting on the Costs of Start-up Activities. The SOP requires that organization costs be expensed as incurred and that unamortized costs be written off and reported as the cumulative effect of a change in accounting principle. However, for those entities meeting criteria specified in Paragraph 23 of the SOP, costs incurred and deferred before June 30, 1998 should continue to be amortized over the remaining life of the original amortization period, or a shorter period if the expected period of benefit is reduced. Such entities must meet all of the following criteria:
(a) the entities' specialized accounting practices include accounting for substantially all investments at market value or fair value;
(b) the entities' shares, units, or ownership interests are issued and redeemed at net asset value; and
(c) the entities' shares, units, or ownership interests were sold to independent third parties (for example, parties other than founders, sponsors, and investment advisors) before June 30, 1998.
Occasionally, a limited partnership agreement of a pool provides that organization costs be repaid to the pool's general partner from the pool's interest income. In such a case, the amounts should not be netted, but shown separately in the statement of income.
V. Confidential Treatment Under FOIA
CPOs are reminded that, pursuant to Commission Rule 145.9, requests for confidential treatment of Annual Reports under the Freedom of Information Act ("FOIA") must
(i) be in writing;
(ii) specify the grounds on which confidential treatment is being requested (for example, that the material would reveal "confidential commercial or financial information.");
(iii) be clearly marked "FOIA Confidential Treatment Request," and contain the name, address and telephone number of the submitter of the information;
(iv) accompany the material for which confidential treatment is being sought (such as the Annual Report); and
(v) state the length of time for which confidential treatment is being sought.
The original of the written request must be sent to the Assistant Secretary of the Commission for FOI, Privacy and Sunshine Acts Compliance. A copy of the request should accompany the material (in this case, the copies of the Annual Report sent to the Division of Trading and Markets.) If the Annual Report is later requested under FOIA, the submitter (in this case, the CPO) will be required to provide a "detailed written justification" for the confidentiality request. In order to ensure that the CPO can be contacted in the event of a FOIA request, the CPO should notify the Assistant Secretary of any changes to CPO's name, address or telephone number.
If a CPO or its accountant has questions concerning the reporting rules, they may contact the following staff members:
Ronald A. Carletta
John S. Dixon
Thank you for your attention to these matters.
Very truly yours,
Henry J. Matecki
Acting Chief Accountant
ADDRESSES OF CFTC DIVISION OF TRADING AND MARKETS OFFICES:
Three Lafayette Centre
1155 21st Street, NW
Washington, DC 20581
300 South Riverside Plaza
Suite 1600 North
Chicago, IL 60606
One World Trade Center
New York, NY 10048
4900 Main Street
Kansas City, MO 64112
APPENDIX - A
Regulation 4.22(f) states the following:
(1) In the event the commodity pool operator finds that it cannot distribute the Annual Report for a pool that it operates with the time specified in paragraph (c) of this section without substantial undue hardship, it may file with the Commission an application for extension of time to a specified date not more than 90 calendar days after the date as of which the Annual Report was to have been distributed. The application must be made by the pool operator and must:
(i) State the name of the pool for which the application is being made;
(ii) State the reasons for the requested extension;
(iii) Indicate that the inability to make a timely filing is due to circumstances beyond the control of the pool operator, if such is the case, and describe briefly the nature of such circumstances;
(iv) Contain an undertaking to file the Annual Report on or before the date specified in the application; and
(v) Be filed with the Commission prior to the date on which the Annual Report is due.
(2) The application must be accompanied by a letter from the independent public accountant answering the following questions:
(i) What specifically are the reasons for the extension request?
(ii) Do you have any indication from the part of your audit completed to date that would lead you to believe that the commodity pool operator was or is not meeting the segregation or recordkeeping requirements of this Part 4?
2 CPOs in Illinois, Indiana, Michigan, Ohio, and Wisconsin file with the CFTC's Chicago Office; CPOs located in other states east of the Mississippi River and those located outside of the U.S. file with the New York office; and CPOs located in states west of the Mississippi River file with the Kansas City office.
3 If a pool ceases operations during the year, an audited report must be provided within 90 days of the permanent cessation of trading, but by no later than 90 days after all funds have been returned to pool participants.