[Federal Register: July 21, 2003 (Volume 68, Number 139)]
[Rules and Regulations]
[Page 42964-42967]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr21jy03-11]

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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 4

RIN 3038-AB39


Performance Data and Disclosure for Commodity Trading Advisors

AGENCY: Commodity Futures Trading Commission.

ACTION: Final rule.

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SUMMARY: The Commodity Futures Trading Commission (``Commission'' or
``CFTC'') is adopting regulations establishing a core principle for
commodity trading advisors (``CTAs'') with regard to performance
disclosures concerning partially-funded accounts. The core principle
specifies that such disclosure must be offered in a manner that is
balanced and is not in violation of the antifraud provisions of the
Commodity Exchange Act (the ``Act'') or the Commission's regulations
thereunder.

EFFECTIVE DATE: August 20, 2003.

FOR FURTHER INFORMATION CONTACT: Kevin P. Walek, Assistant Director,
telephone: (202) 418-5463 or Eileen Chotiner, Futures Trading
Specialist, telephone: (202) 418-5467, Division of Clearing and
Intermediary Oversight, Commodity Futures Trading Commission, Three
Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581. E-mail: 
kwalek@cftc.gov or echotiner@cftc.gov.

SUPPLEMENTARY INFORMATION:

I. Background

    On March 13, 2003, the Commission published in the Federal Register
\1\ proposed rule amendments 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.
In that release, the Commission also sought comment on whether a core
principle should replace detailed performance requirements.
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    \1\ 68 FR 12001 (Mar. 13, 2003).
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    The Commission received thirteen comments on the proposal. The
commenters included one industry association,\2\ one CTA,\3\ one bar
association,\4\ one consumer organization,\5\ one accounting firm,\6\
the National Futures Association (``NFA''), and seven members of the
public.\7\ The industry and bar associations, NFA, and the CTA
supported the amendments, particularly the use of nominal account size
as the basis for computing rates of return. The seven members of the
public and the consumer organization submitted comments expressing
concern over the use of nominal account size rather than actual funds
as the basis for presentation of a CTA's past performance. Commenters
who addressed the core principle approach indicated that specific
standards for performance presentation should exist in an area in which
continuity and comparability are important, although several indicated
that additional flexibility in the application of those standards would
be welcome. These comments are discussed more fully below.
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    \2\ Managed Funds Association (``MFA'').
    \3\ John Henry & Company, Inc.
    \4\ Association of the Bar of the City of New York, Committee on
Futures Regulation.
    \5\ Consumer Federation of America (``CFA'').
    \6\ Arthur F. Bell, Jr., & Associates, LLC.
    \7\ One of these commenters, Paul H. Bjarnason, Jr., is an
accountant and former Commission employee. Six commenters, Elizabeth
M. Buckman, Bonnie Kayser, James S. Finucane, Christine E. Schoen,
Laura M. Stephens, and Ray Weaver, submitted identical letters.

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[[Page 42965]]

II. Final Rules

A. Use of Nominal Account Size and Other Detailed Performance
Requirements in the Proposal

    The key component of the Commission's rule proposal is the use of
nominal account size, rather than actual funds, as the basis for CTAs'
computation of rates of return. The consumer organization and members
of the public noted that investors look at actual funds when making
investment decisions, and expressed concern that performance based on
nominal account size would reduce the appearance of volatility of the
CTA's trading program. Commenters who supported use of nominal account
size noted that it is the amount both the CTA and the client consider
to be the account size. They also pointed out that use of actual funds
can result in widely divergent return figures for similarly traded
accounts; exaggerates positive and negative rates of return; and
measures the cash management strategies of clients rather than the
performance of the CTA.
    The Commission has not found persuasive the comments opposing use
of nominal account size rather than actual funds as the basis for
computing CTA rates of return. Some commenters and press reports appear
to have misunderstood the intent of past performance reporting under
Commission rules--to present to prospective clients information on how
the trading program, which the CTA is offering, has performed. The
amount of actual funds in a client's account is determined by the
client and its FCM, not the CTA, and does not affect the CTA's trading
decisions based on nominal account size. Use of nominal account size
would permit CTAs to present to prospective clients composite
performance results that will be consistent for the accounts within the
program, even if those accounts have widely divergent amounts of actual
funds supporting the same level of trading. The alternatives--either
blending all accounts, regardless of the variation in funding levels,
into a single actual funds-based table, or presenting multiple
performance tables to address each individual funding level--could be
less informative and potentially more confusing to prospective clients.
    The Commission similarly does not agree that disclosure of the
volatility and risk of a CTA's trading program will be reduced if the
nominal account size is used. As NFA noted in its comment letter, the
proposed use of nominal account size would not understate either
volatility or risk, as the dollar amount of any profit or loss will be
the same for accounts with the same nominal account size, regardless of
the funding level. Further, whatever incentive a CTA may have to make
its losses appear smaller would be offset by the fact that calculating
rate of return on a larger nominal account size would reduce the
appearance of profits as well.

B. Adoption of a Core Principle

    In seeking comment on the desirability of implementing a core
principle in the proposing release, the Commission cited Congressional
intent as expressed in the Commodity Futures Modernization Act of 2000
(``CFMA'').\8\ Section 125 of the CFMA required 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 could be replaced with core
principles.\9\ While commenters participating in the study expressed
concerns regarding replacement of regulations with core principles in
certain contexts, they did identify a number of areas where existing
rules could be modified or eliminated.\10\ Several commenters on the
current proposal noted that the flexibility offered by a core principle
might not adequately address the need for a standard method of
calculating performance that will enable continuity and comparability
in the presentation of CTAs' rates of return. The Commission believes,
however, that a core principle adopted by the Commission would not
preclude the development of more explicit guidance or performance
standards by the Commission, self-regulatory organizations, and/or an
independent organization, as one commenter suggested, that is otherwise
consistent with the core principle.\11\ The Commission understands that
NFA plans in the near future to adopt specific rules regarding
presentation of partially funded accounts that would apply to all
member CTAs,\12\ and that would be consistent with the rules proposed
by the Commission.\13\ Although the Commission agrees that nominal
account size is an appropriate basis for calculating performance
results, the Commission encourages NFA, in the development of guidance
carrying out a core principle approach, to consider whether or not
these nominal account performance results can be supplemented with
other performance measures or statistics that enable customers with
accounts that are not fully funded to generally gauge performance
results for these types of accounts. The Commission further notes that
CTAs presenting partially funded account performance in accordance with
the detailed requirements in its March 2003 rule proposal \14\ will be
considered to be in compliance with the core principle.
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    \8\ Pub. L. 106-554, 114 Stat. 2763 (2000) (codified as amended
in scattered sections of 7 U.S.C.).
    \9\ A copy of the study may be viewed on the Commission's Web
site at:  href="http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=www.cftc.gov/files/opa/opaintermediarystudy.pdf" shape="rect">http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=www.cftc.gov/files/opa/opaintermediarystudy.pdf.
    \10\ Report on the Study of the Commodity Exchange Act and the
Commission's Rules and Orders Governing the Conduct of Registrants
Under the Act, p. 25. In certain areas, commenters mentioned
concerns with regard to the practicability and legal certainty of
core principles.
    \11\ For example, the Association for Investment Management
Research (``AIMR''), an international nonprofit organization of
investment practitioners and educators, has developed voluntary
standards for presentation of investment performance that are used
by many investment managers and advisers. AIMR's Investment
Performance Council recently issued an invitation to comment on
proposed guidance regarding leverage and derivatives to be added to
its Global Investment Performance Standards (GIPS). Neither the
existing GIPS standards nor the proposed guidance directly addresses
the partial funding issue that is the subject of the core principle
adopted herein. As standards such as AIMR's evolve to address this
issue, they may provide additional guidance to persons or
organizations seeking to comply with this core principle or seeking
to develop best practices in this area.
    \12\ With exceptions not otherwise pertinent here, a CTA that
conducts futures business with the public and is required to
register with the Commission must be a member of NFA, pursuant to
NFA Bylaw 1101.
    \13\ Any rules adopted by NFA would be submitted to the
Commission according to the review process for rules of a registered
futures association provided in Section 17(j) of the Act.
    \14\ See note 1.
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    After evaluating the comments received on both the detailed
proposed amendments and the alternative of a core principle described
in the proposal, the Commission has determined not to adopt the
detailed proposed rules, but rather to amend Commission Rule 4.35(a)
\15\ so as to permit CTAs to comply with a core principle with respect
to the performance of partially-funded accounts. While the Commission
is fully supportive of the content and approach of its detailed rule
proposal of March 2003, the history of discourse on this issue suggests
that any prescriptive rule adopted by the Commission could soon be
inconsistent with evolving industry developments and practices in this
area. The flexibility of a core principle, rather than a single set of
rigid requirements, would ensure that core Commission regulatory
concerns are complied with without impeding legitimate business needs.
The Commission believes that this approach is consistent with the
objective of the CFMA that the Commission, when

[[Page 42966]]

appropriate, permit the industry flexibility in the manner it complies
with certain regulatory mandates. Moreover, a core principle regarding
the presentation of past performance of partially funded accounts is
consistent with the approach governing use of promotional material by
CTAs and commodity pool operators (``CPOs'').\16\ In addition, as noted
in the proposing release, a core principle approach would also be
consistent with Federal securities laws applicable to investment
advisers, who generally may present past performance in any manner that
does not run afoul of general anti-fraud provisions.\17\
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    \15\ Commission rules referred to herein may be found at 17 CFR
Ch. I (2002).
    \16\ Commission Rule 4.41 reiterates the anti-fraud provisions
of Section 4o of the Act. NFA has promulgated its Compliance Rule 2-
29 and issued interpretive notices, which provide more detailed
guidance on the preparation and use of promotional material.
    \17\ 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). The SEC's general
antifraud approach to performance disclosure, which is analogous to
the core principle approach adopted herein, has not impeded the
SEC's ability to bring enforcement actions for inappropriate
disclosure. 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.
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    The core principle requires that the disclosure must be presented
in a manner that is balanced and is not in violation of the antifraud
provisions of the Commodity Exchange Act (the ``Act'') or the
Commission's regulations thereunder.\18\ Each of these two requirements
must be complied with in order for the core principle to be met. First,
the presentation must not violate the antifraud provisions of the
Commodity Exchange Act. For example, a materially misleading disclosure
would violate those provisions,\19\ and thus would violate this core
principle. In addition, the presentation must be balanced. For example,
a presentation that emphasizes past gains and minimizes past losses
would fail to meet this requirement, and thus would violate the core
principle.\20\
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    \18\ 7 U.S.C. 1 et seq. (2000); 17 CFR Ch. I (2002). Antifraud
provisions under the Act and regulations include Sections 4b, 4o,
and Regulations 1.1, 4.41, 30.9, 32.9 and 33.10.
    \19\ See, e.g., In re Slusser, [1998-1999 Transfer Binder] Comm.
Fut. L. Rep. (CCH) para. 27,701 at 48,311 (CFTC July 19, 1999),
aff'd in part and rev'd in part on other grounds sub nom. Slusser v.
CFTC, 210 F.3d 783, 784 (7th Cir. 2000).
    \20\ See also National Futures Association Compliance Rule 2-
29(b)(3) (prohibiting the use of promotional material that
``mentions the possibility of profit unless accompanied by an
equally prominent statement of the risk of loss.'') NFA has issued
guidance interpreting this rule, see, e.g., NFA Interpretive Notices
para. 9003.
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    Although a few commenters expressed concern that a core principle
might impede the Commission's enforcement efforts, or limit them to
``the most egregious cases,'' the Commission believes that the adoption
of a core principle based on existing antifraud provisions, which also
requires balance, in no way diminishes its current ability to address
improper disclosure, nor its ability to address violations of that core
principle consistent with its current authority to enforce the
antifraud provision of the Act. The SEC has successfully brought
actions under its anti-fraud authority against those who have used
misleading performance presentations,\21\ and NFA has successfully
disciplined members who have used unbalanced promotional material.\22\
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    \21\ See, e.g., In Re F.X.C. Investors Corp. and Francis X.
Curzio 79 SEC 276 (2002) (Distribution of misleading performance
information violates section 206(4) of Investment Advisers Act and
SEC Rule 275.206(4)-1(a)(5)).
    \22\ See, e.g., Minogue Investment Company, Inc. (NFA Case No.
98-App-006); Vision Limited Partnership (NFA Case No. 00-BCC-005).
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    In addition to the amendment to Rule 4.35, the Commission is also
adopting the definition of a ``partially-funded account'' and a
conforming amendment to Rule 4.25 regarding the presentation of a CTA's
partially-funded account performance in a commodity pool disclosure
document.
    The rule amendments being adopted herein relate solely to
partially-funded accounts. In that regard, Advisory 93-13,\23\ which
the proposing release stated would be superseded by the adoption of the
proposed rule amendments, will remain in effect until such time as the
Commission and/or an appropriate self-regulatory organization adopts
further guidance on the presentation of partially funded accounts.
Other issues noted in the proposal published March 13, 2003, regarding
performance presentation generally, such as changes in the calculation
of drawdown figures and application of the Commission's 1991 Advisory
concerning additions and withdrawals,\24\ will be addressed in a
subsequent Federal Register release.
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    \23\ CFTC Advisory 93-13, 58 FR 8226 (February 12, 1993).
    \24\ 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 (Feb.
27, 1991).
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III. Other Matters

A. Regulatory Flexibility Act

    The Regulatory Flexibility Act, 5 U.S.C. 601 et seq., requires that
agencies, in promulgating 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 Regulatory Flexibility Act.\25\ The Commission previously has
determined that registered CPOs are not small entities for the purpose
of the Regulatory Flexibility Act.\26\ 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 for purposes of the Regulatory
Flexibility Act and, if so, to analyze the economic impact on them of
any such rule at that time.\27\ The Commission has previously
determined that disclosure requirements governing CTAs do not have a
significant economic impact on a substantial number of small
entities.\28\ Moreover, the amendments being adopted herein do not
impose additional requirements on CTAs, but rather offer CTAs an
alternative means by which to comply with existing Commission rules.
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.
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    \25\ 47 FR 18618-18621 (Apr. 30, 1982).
    \26\ 47 FR 18619-18620.
    \27\ 47 FR 18618-18620.
    \28\ See 60 FR 38146, 38181 (July 25, 1995) and 48 FR 35248
(Aug. 3, 1983).
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B. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 (``PRA'')\29\ imposes certain
requirements on federal agencies (including the Commission) in
connection with their conducting or sponsoring any collection of
information as defined by the PRA. These rule amendments do not require
a new collection of information on the part of any entities subject to
the rule amendments. Accordingly, for purposes of the PRA, the
Commission certifies that these rule amendments will not impose any new
reporting or recordkeeping requirements.
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    \29\ 44 U.S.C. 3501 et seq.
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C. Cost-Benefit Analysis

    Section 15(a) of the Act requires the Commission to consider the
costs and benefits of its action before issuing a new regulation under
the Act. By its terms, Section 15(a) does not require the Commission to
quantify the costs and benefits of a new regulation or to determine
whether the benefits of the proposed regulation outweigh its costs.
Rather, Section 15(a) simply requires

[[Page 42967]]

the Commission to ``consider the costs and benefits'' of its action.
    Section 15(a) further specifies that costs and benefits shall be
evaluated in light of five broad areas of market and public concern:
Protection of market participants and the public; efficiency,
competitiveness, and financial integrity of futures markets; price
discovery; sound risk management practices; and other public interest
considerations. Accordingly, the Commission could in its discretion
give greater weight to any one of the five enumerated areas and could
in its discretion determine that, notwithstanding its costs, a
particular rule was necessary or appropriate to protect the public
interest or to effectuate any of the provisions or to accomplish any of
the purposes of the Act.
    The Commission is considering the costs and benefits of these rules
in light of the specific provisions of Section 15(a) of the Act:
1. Protection of Parket Participants and the Public
    The amendments being adopted herein are not expected to result in
less protection of market participants or the public. Rather, the
amendments provide the opportunity for a more meaningful and accurate
disclosure, as demanded by marketplace forces. Moreover, the
Commission, along with NFA, will continue to monitor the presentation
of performance by CTAs and take action wherever necessary.
2. Efficiency and Competition
    The amendments are expected to increase efficiency by providing a
CTA with increased flexibility for providing past performance. With
this flexibility, a CTA will be better able to respond to changes in
the industry and demands from the marketplace with regard to the
disclosure of the CTA's past performance.
3. Financial Integrity of Futures Markets and Price Discovery
    The amendments should have no effect, from the standpoint of
imposing costs or creating benefits, on the financial integrity or
price discovery function of the commodity futures and options markets.
4. Sound Risk Management Practices
    The amendments should have no effect on sound risk management
practices.
5. Other Public Interest Considerations
    The amendments being adopted herein provide more flexibility for
CTAs in being able to present past performance in a manner that more
accurately represents the trading results of their systems, while
maintaining adequate safeguards so as to protect prospective clients
from misleading or fraudulent solicitations.
    After considering these factors, the Commission has determined to
issue the amended rules.

List of Subjects in 17 CFR Part 4

    Advertising, Commodity Futures, Customer Protection, Reporting and
recordkeeping.

0
For the reasons discussed in the foregoing, the Commission hereby
amends Chapter I of Title 17 of the Code of Federal Regulations as
follows:

PART 4--COMMODITY POOL OPERATORS AND COMMODITY TRADING ADVISORS

0
1. The authority citation for Part 4 continues to read as follows:

    Authority: 7 U.S.C. 1a, 2, 6(c), 6b, 6c, 6l, 6m, 6n, 6o, 12a and
23.

0
2. Section 4.10 is amended by adding paragraph (m) to read as follows:


Sec.  4.10  Definitions.

* * * * *
    (m) Partially-funded account means a client participation in the
program of a commodity trading advisor in which the amount of funds in
the client's commodity interest account over which such commodity
trading advisor has trading authority is less than the account size
that establishes the client's level of trading in a commodity trading
advisor's program.
0
3. Section 4.25 is amended by adding paragraph (a)(1)(ii)(H) to read as
follows:


Sec.  4.25  Performance disclosures.

* * * * *
    (a) * * *
    (1) * * *
    (ii) * * *
    (H) Partially-funded accounts directed by a commodity trading
advisor may be presented in accordance with Sec.  4.35(a)(7).
* * * * *
0
4. Section 4.35 is amended as follows:

0
a. By redesignating paragraphs (a)(7) and (a)(8) as (a)(8) and (a)(9)
respectively;
0
b. And adding new paragraph (a)(7) to read as follows:


Sec.  4.35  Performance disclosures.

* * * * *
    (a)(7) Performance of partially-funded accounts. Notwithstanding
the foregoing, a commodity trading advisor will be deemed in compliance
with this Sec.  4.35(a) concerning the performance of partially-funded
accounts if the commodity trading advisor presents the performance of
such accounts in a manner that is balanced and is not in violation of
the antifraud provisions of the Commodity Exchange Act or the
Commission's regulations thereunder.
* * * * *

    Issued in Washington, DC, on July 15, 2003 by the Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 03-18413 Filed 7-18-03; 8:45 am]
BILLING CODE 6351-01-P