Review of the FCM and IB

Financial and Sales Practice Compliance Program

of

National Futures Association

�

Commodity Futures Trading Commission

Division of Trading and Markets

September 1998

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I. INTRODUCTION

This is a report on the Division of Trading and Markets� ("Division") review of the design and execution of the financial and sales practice compliance program ("program") of National Futures Association ("NFA") as it applies to futures commission merchants ("FCMs") and introducing brokers ("IBs"). The section of this report entitled "Scope of the Review" and the sections covering each of the specific areas of the Program explain the extent of the Division�s review. The Division�s most recent prior reports on NFA�s programs were in July 1997, September 1995 and July 1994. The 1997 report covered NFA�s compliance program for commodity pool operators ("CPOs") and commodity trading advisors ("CTAs"), the September 1995 report covered NFA's program for financial and sales practice compliance in the managed funds area, and the July 1994 report covered the FCM and IB program, as does the current report.

This review is part of the Division's ongoing program of reviews, which have been conducted periodically for many years, to assess the design and overall effectiveness of self-regulatory organization ("SRO") rule enforcement programs. The reviews are intended to identify specific deficiencies in the execution of established procedures or areas that could be improved or enhanced.

In conducting its review, the Division employs techniques which rely heavily on the sampling of audit workpapers, files, records and other documents prepared and retained by the SRO being reviewed, as well as interviews of SRO staff. The success of a review depends in large measure on the willing cooperation of SRO management and staff, and the completeness and accuracy of the documentation and representations provided by SRO management in support of its Program. Therefore, a review will not necessarily uncover every program failure or identify every needed improvement.

The Division conducted this full-scope review through a series of interim reviews performed over the course of the target review period. Interim reviews of an SRO�s program are made by the Division in order to maintain ongoing contact and familiarity with the status of the relevant SRO�s financial rule and sales practice enforcement programs. Any significant findings discovered by the Division during an interim review are brought to each SRO's attention at the time they are found in order to initiate prompt corrective action. In preparing the formal written report of its oversight activities, the Division draws upon the results of all of the interim reviews conducted since the last formal written report. This report generally covers the time period January 1, 1996 through June 30, 1998, although data on certain topics reviewed covered the period January 1, 1996 through December 31, 1997.

II. FINDINGS AND RECOMMENDATIONS

The Division found that NFA's Program is well designed, that its compliance staff generally execute their duties thoroughly, and that the Program complies with applicable regulatory requirements. The Division has no major recommendations for the enhancement of NFA�s Program. (When minor recommendations are developed, they are made on a staff-to-staff basis during the course of the review work.)

As a part of the current review, the Division followed up on recommendations contained in its prior report on NFA�s Program, issued in July 1994. In addition, the Division followed up on a review of subordinated loan prepayments, issued in August 1997. As set forth below, the Division found that NFA has, for the most part, taken appropriate action.

III. FOLLOW-UP ON PRIOR RECOMMENDATIONS

The Division found that NFA generally addressed the concerns raised in the 1994 Report, as described below:

Recommendation No. 1 - Improved Information on Affiliated Entities

The Division recommended that NFA consider capturing, in its computerized information system, certain information on entities affiliated with all classes of registrants for which NFA is the designated self-regulatory organization ("DSRO"). The Division suggested that NFA include a brief explanation of the nature of any business affiliation that could have an impact upon the regulated entity. The Division noted that NFA had developed specific audit procedures to address the financial audit issues raised by the existence of affiliated entities and transactions with affiliates. NFA's audit program calls for NFA to consult with other regulators, where an affiliate of a firm being audited by NFA is regulated by another commodities SRO or by a securities regulator. However, information regarding affiliated entities developed by NFA during an audit is retained only in NFA�s audit workpapers. This information, therefore, was not being maintained in a readily identifiable or accessible form.

Current status of recommendation:

Although information on affiliates still is not maintained on NFA�s Financial Analysis, Audit, Compliance, Tracking System ("FACTS"), such information is readily available in NFA's audit workpapers, which are stored on NFA�s central computer, and may be accessed upon demand. Further, NFA's audit programs require review of a firm�s organizational structure, including a review of information on affiliated entities.

In addition, since the prior report was issued, the Commission�s Regulations 1.14 and 1.15, the risk assessment recordkeeping and reporting requirements for futures commission merchants, have become effective.1 The Commission now receives information about some firms' organization and affiliates directly from FCMs covered by these regulations.

Recommendation No. 2 - Failure To Report Audit Delays

Division of Trading and Markets Financial and Segregation Interpretation
No. 4-1 ("Interpretation No. 4-1") requires an SRO to notify the Division of any audit that is not completed within five months from the date it is started. The Division had found two instances where NFA failed to notify the Division of completion delays. While there were lapses in reporting by NFA, they were not due to any financial problems at the registrants being audited. It appeared NFA failed to report because it had been relying on its audit managers to initiate such notifications to the Division. The Division suggested that such reporting responsibilities be assumed by the NFA headquarters staff responsible for audit scheduling and tracking.

Current status of recommendation:

In reviewing the timing of audits during the current review, from January 1, 1996 through December 31, 1997, Division auditors found no instances in which an audit had been outstanding for more than five months. Therefore, NFA appears to be adequately monitoring audit completion to ensure completion within five months from the date an audit is initiated.

Recommendation No. 3 - Record of Surprise Audits

Interpretation No. 4-1 provides that audits designed to verify that an FCM�s books and records are maintained on a current basis be conducted on a surprise basis. The Division found that NFA�s audit control records did not reflect whether an audit had been conducted on a surprise basis. The Division recommended that NFA start capturing this information in its control record.

Current status of recommendation:

The Division's review of NFA�s FACTS "Recordkeeping Log" for eight FCM audits disclosed that the "Announced" indicator for each audit had an "N." The "N" means the audit was not announced to the FCM but was instead a surprise audit. In the current review, Division staff verified that the "Announced" indicator now appears on FACTS for all registration categories subject to audit. In addition, Division staff compared the audit start dates shown in FACTS to the audit start dates identified in NFA's audit workpapers. The audit start dates were the same dates in both records for each of the FCM audits the Division reviewed.

Based upon NFA�s assurances that FCM audits are performed on a surprise basis, and the FACTS audit control record now disclosing "announced" audits for FCM and non-FCM categories, it appears that NFA has addressed the recommendation satisfactorily. NFA�s practice of performing surprise audits of FCMs meets the requirements of Division Interpretation No. 4-1, paragraph 28.

Recommendation No. 4 - Submission of NFA Guides for Division Review

NFA has developed many guides that help its members to understand and comply with regulatory requirements and that help them in preparing various types of filings. The Division found that, while the guides generally are thorough and accurate, there are occasional errors and omissions. Also, some of the guides contain statements that may be construed as interpretations of the Commission�s requirements. Accordingly, the Division recommended that NFA submit its guides to the Division for review prior to publication.

Current status of recommendation:

NFA agreed to submit copies of its guides to the CFTC for review prior to publication. The most recent publication date for NFA's FCM/IB Regulatory Guide is March 1998, and for the CPO/CTA Regulatory Guide it is January 1996. Although the CPO/CTA regulatory guide was submitted to the Division for review prior to its publication, the Division did not receive the FCM/IB regulatory guide prior to its publication and an NFA representative confirmed that the guide was not made available to the Division. Division staff have expressed their concern about this to NFA staff, who have assured us that the CPO/CTA guide which is currently being revised will be forwarded to the Division for comment before publication.

Recommendation No. 5 - Enhancement of Sales Practice Surveillance

In a July 27, 1994 letter to the Joint Audit Committee ("JAC"),2 the Division recommended that the JAC consider ways to refine sales practice surveillance over FCMs, to ensure that all classes of potentially unsophisticated customers are included within the scope of the accounts subject to sales practice surveillance by the futures industry�s SROs. The Division also recommended that sales practice review and audit procedures, including scope-setting, and the definition of "retail" account, be broadened to include any account which may be held or participated in by unsophisticated persons. Since NFA uses profile information (with regard to the retail nature of a firm's accounts) supplied to it by other SROs in making a determination as to the coverage required in response to its sales practice audit responsibilities, the Division recommended that NFA take steps, through the JAC, to ensure the adequacy of the scope of the information supplied to it by other SROs.

Current status of recommendation:

The JAC expanded the definition of "Retail Firm" to address the Division�s concerns and to comply with the recommendation. The information is being collected where applicable.

Recommendation No. 6 - Review of Laptop Audits

The Division reviewed three laptop audits3 performed by NFA�s New York office. The Division found that the laptop audits were of the same quality as NFA�s hard copy-based audits. However, they were somewhat more difficult to review than hard copy audit files. The Division made several suggestions to NFA as to how the system could be changed to facilitate the review process. For example, the Division recommended that NFA establish a standard work-paper index for each type of laptop audit and, further, recommended format changes that would eliminate irrelevant information. NFA agreed with the suggestions, and also has done its own evaluation of the laptop audits, resulting in other modifications to facilitate review of the electronic files. In addition, NFA agreed to provide training for the Division�s staff in the use of the laptop audit system software.

Current status of recommendation:

The Division audit staff has attended NFA lap-top computer audit training since NFA first offered to provide it in 1994. Subsequent to the training, Division staff has had several opportunities to review NFA lap-top computer audits. In reviewing documentation by NFA staff of the audits they performed, the Division found that the latest versions of the lap-top audit software are easier to use than those reviewed earlier by the Division, reflecting the steady evolutionary improvement of this approach to audit documentation.

* * * * *

Informal Recommendation: NFA Approval Required for Prepayment of Subordinated Loans.

In August 1997 the Division reviewed NFA�s system of processing subordinated loan agreements ("SLAs"), including requests for prepayment. The Division made an informal recommendation regarding the approval process that was adopted by NFA. The Division found that FCMs were making prepayments of their subordinated loans without first receiving written approval from NFA to do so. Section C1-b(vii) of NFA�s Financial Requirements provides that no prepayment shall occur without prior written approval from NFA. NFA also was unable to locate certain correspondence relating to the prepayments.

NFA�s Response:

NFA responded that there were no instances where a prepayment was approved when it should not have been, and that written approval of the prepayment was always given.4 NFA did not agree with the Division�s finding that approvals of prepayments were made retroactively. NFA stated that the prepayment requests cited in the Division�s report were reviewed by NFA promptly upon receipt, and the FCMs were notified verbally of NFA�s approval at the conclusion of NFA�s review, with written approvals sometimes sent later.

NFA also stated that to ensure that prepayments of SLAs are not made without prior written approval, it has established the following procedures. A written notice of NFA�s approval of an SLA prepayment will be faxed or e-mailed to the firm on, or before, the effective date of the prepayment request. This letter will indicate the effective date of the approval of the prepayment request, which will not be before the date of the approval letter. As has been the case, staff compliance letters will be sent to those firms that prepay SLAs before receiving NFA's approval. In addition, in order to improve recordkeeping in this area, NFA agreed to keep copies of both the prepayment request and the approval letter in the correspondence file of the supervisor or manager who approves the request.

Follow-up on Corrective Action:

The Division selected nine prepayment requests received by NFA from six FCMs to determine whether NFA was providing prior written approval of the prepayment to the firms, and to determine whether NFA�s correspondence relating to each prepayment request was complete. The review disclosed that NFA provided written approval for the prepayments to the firms for each of the nine prepayment requests. NFA provided the Division with copies of prepayment requests and NFA approval letters for all nine requests. However, three of the nine prepayment requests were submitted to NFA after the prepayments had been made. For those occurrences, NFA issued each firm a staff letter for failing to advise NFA and obtain NFA approval prior to making prepayments. Based upon the Division�s review, it appears that NFA is maintaining records of subordinated loan prepayment requests and NFA�s approval of these requests, as well as sending staff letters to firms who have failed to request NFA's approval in advance of making prepayments.

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IV. SCOPE OF THE CURRENT REVIEW

This review is part of a continuing program by the Division to assess the effectiveness of SRO programs. The Division reviewed NFA�s Program to ascertain whether it met pertinent regulatory requirements, particularly those under Interpretation No. 4-1, and to identify areas where enhancements could be made. In this review, the Division interviewed officials of NFA and reviewed:

1. Membership lists, including the Membership and Registration Directory, which identifies the membership and registration categories held;

2. Audit programs, manuals, and procedures;

3. NFA Audit Priority System (for FCMs and IBs);

4. Audit Log - identifies all field examinations made in numerical order by examination number and all examinations made of each member firm by membership category(s);

5. Audit workpapers and written reports for financial and compliance audits and limited scope reviews of FCMs and IBs. Division staff selected a sample of firms for review;

6. Financial Reports Tracking System - lists and tracks the timeliness of all financial reports filed by FCMs and IBs;

7. Documentation of the execution of the daily financial surveillance program;

8. Record of Legal Actions - lists of disciplinary actions taken and warning letters issued;

9. Year 2000 Preparations � review of NFA�s plans and procedures; and,

10. Record of customer complaints and follow-up.

The Division�s auditors selected a sample of items for review. Exhibit No. 1 shows the number of financial/compliance audits, limited scope reviews, and branch office reviews carried out by NFA during 1996 and 1997.

V. BACKGROUND

A. National Futures Association

NFA was designated by the Commission as a "registered futures association" on September 22, 1981, pursuant to the provisions of Section 17(p) of the Commodity Exchange Act ("CEAct"). Section 17(p) requires NFA to adopt rules establishing training standards and proficiency testing for persons involved in the solicitation of transactions subject to the provisions of the Act, supervisors of such persons, and all persons for whom it has registration responsibilities, and to create a program to audit and enforce compliance with such standards. NFA is also required to establish minimum capital, segregation, and other financial requirements applicable to its members for whom such requirements are imposed by the Commission and to implement a program to audit and enforce compliance with such requirements. Finally, NFA is required to establish minimum standards governing the sales practices of its members and members� associated persons.

B. Regulatory Basis for NFA�s Program

NFA has incorporated by reference in its Rules the Commission�s segregation, record keeping, and related reporting regulations for FCMs, CPOs, IBs and CTAs. In addition, NFA has adopted net capital rules for FCMs and IBs, which, as required by the Commodity Exchange Act, are no less stringent than those of the Commission.

As a registered futures association, NFA is considered an SRO and must, in carrying out its financial audit and surveillance activities, comply with the requirements of Commission Regulations 1.51 and 1.52, and the Division�s Interpretation No. 4-1.

C. The Joint Audit Plan and the Joint Audit Committee

By formal agreement, all futures SROs, including NFA, are members of the JAC and, hence, participate in a joint audit plan that has been approved by the Commission pursuant to Rule 1.52(g). The purpose of the joint audit plan is to coordinate futures industry sales practice and financial surveillance programs, to assure efficient program coverage, and to avoid duplicative audits of FCMs. That is, the arrangements under the joint audit plan ensure that those FCMs that are members of more than one SRO are subject to routine periodic audits by only one SRO. Each FCM has an SRO designated by the JAC, referred to as the "DSRO," that is responsible for routine in-field audit and financial surveillance activities over that firm. In addition to the FCMs for which it is responsible, NFA is also responsible for regulatory compliance matters with respect to its member IBs, except for IBs that are guaranteed by an FCM that does not have NFA as its DSRO. See Exhibit 3 for a summary of FCMs and DSRO assignments.5 In the event that a DSRO discovers an apparent violation of a Commission rule or the rule of another SRO, the matter will be referred to the relevant SRO or to the Commission for appropriate follow-up and possible action. Any recommendation that the Division makes regarding the written programs applicable to an individual SRO's in-field audit program is considered for adoption by the JAC as part of its annual written program review and update.

D. Profile of NFA�s Membership

NFA�s membership includes registered FCMs, CPOs, IBs, CTAs and U.S. commodity exchanges. Commercial firms and banks are represented on the Board of Directors as Public Directors. Though not required to register with the Commission, the commercial firms and banks use the commodity markets for hedging and price referencing.

There were 230 FCMs that were members of NFA as of December 31, 1997. Most of these FCMs carry funds of customers trading commodities and therefore must, under Commission Regulation 170.15, become members of a registered futures association. NFA is the only such association at the present time. NFA Bylaw 1101 prohibits an NFA member from doing business with a non-member (other than a floor broker) that is required to register with the Commission as an FCM, IB, CPO, CTA or leverage transaction merchant ("LTM") that is acting with respect to an account, order or transaction for a customer, a commodity pool or participant therein, a client of a CTA, or any other person. Consequently, an IB, CPO, or CTA that conducts commodity business with the public and with a member of NFA must be a member of NFA.

E. Staffing and Organization of NFA�s Compliance Function

NFA�s principal office is located in Chicago, Illinois, with a second office in New York. The Chicago office compliance staff is responsible for 35 central and western states and all U.S. territories and possessions. The New York office compliance staff is responsible for 15 states and the District of Columbia. As of December 31, 1997, NFA�s compliance staff totaled 143, with 110 located in Chicago and 33 located in New York. NFA as a matter of policy generally hires new staff at the entry level and promotes from within to supervisory positions. NFA continuously develops its staff by providing in-house, continuing education throughout the year for all levels of staff. For the many staff members who are certified public accountants ("CPAs"), NFA training has been certified as meeting the continuing professional education requirements for a CPA who holds a state license to practice public accounting.6

Effective February 1998, NFA reorganized its compliance department. Under the old structure there were Associate Directors, Managers, Supervisors, Senior Auditors, In-Charge Auditors, Experienced and Staff Auditors. Under the new structure, the number of managerial levels has been reduced, and there are now only Associate Directors, Team Managers, Field Supervisors (experienced on-site auditors), and Staff Auditors. This new organizational structure also includes a team dedicated solely to the review of disclosure documents.7

Compliance Staff Experience as of December 31, 1997

Less than one year: 28

One to three years: 53

Over three years: 62

Total: 143

The total number of compliance staff has remained fairly constant in the last few years. Compliance staff turnover averaged 25% per year over the four-year period ending December 31, 1997. The Division�s July 1994 review disclosed that compliance staff turnover averaged about 15% per year from 1990 through 1994.

NFA seeks to achieve continuity by assigning the audits of its registrants to the same audit team from one period to the next. While junior auditors may change, NFA keeps the same senior auditors from one year to the next for the FCMs. The same audit team is also responsible for reviewing the financial reports filed by a particular registrant.

F. Employee Conflicts of Interest

Compliance Department employees are subject to Commission Regulation 1.59, which prohibits employees of an SRO from disclosing material, non-public information to any other person, except in the course of their duties, and from trading, either directly or indirectly, any commodity interest based on such information, when the employee has gained access to that information through the performance of their regular duties. To implement compliance with this regulation, NFA has adopted a code of professional conduct whereby all employees are required to complete a code of professional conduct questionnaire, which is renewed annually, or whenever changes occur.

The Division reviewed twelve personnel records of NFA compliance staff. The review revealed that all files contained a properly completed questionnaire as of the latest report period. All potential conflicts of interest noted on the questionnaires sampled had been forwarded to the General Counsel and found to be permissible. Two questionnaires sampled revealed relatives working for firms in the industry. In those instances the General Counsel sent a memo to the involved employee�s supervisor, alerting the supervisor to the situation, and informing the supervisor so that the NFA employee "...will not be assigned to matters that may place him in a potential conflict of interest situation."

G. Year 2000 Preparations

The Division has been monitoring NFA�s year 2000 preparedness activities. The NFA Compliance Department is participating in the JAC year 2000 project as well as obtaining year 2000 information through NFA�s initiative. NFA mailed JAC�s "Year 2000 Compliance Questionnaire" to the 50 omnibus FCMs for which NFA is the DSRO. Additionally, NFA devised an "NFA Year 2000 Questionnaire" for fully disclosed FCM�s, active independent IBs, and CPOs and CTAs with more than $1 million under management. The JAC questionnaire was mailed on February 29, 1998 and the NFA questionnaire was mailed on April 15, 1998. NFA has received responses for both of the questionnaires, and presently is reviewing the responses.

The Compliance Department is conducting follow-up calls to questionnaire recipients that have not responded. Staff members are involved in the follow-up process daily. The Division is receiving monthly status reports from NFA on their follow-up results. Additionally, NFA plans to review and update the questionnaire responses with each member FCM during the next annual audit. Because FCMs are audited annually, on-site review of each questionnaire response will be accomplished for all FCMs well before the arrival of the year 2000.

VI. PROGRAM AREAS

A. General Surveillance/Information Gathering

1. Financial Analysis and Compliance Tracking System ("FACTS")

NFA�s FACTS is computerized and includes the following subsystems:

i. Statement/Document Analysis - performs analysis of financial statements filed by members, including comparison and trend analysis.

ii. External Tracking - maintains up-to-date information on members, such as fiscal year-ends, exchange memberships, pools operated, guaranteed IBs, and omnibus accounts.

iii. Internal Tracking - monitors documents such as financial reports filed by members and follows the flow of those documents through various stages of review.

iv. Management Control - alerts NFA management to critical problems identified by the system, such as members with possible financial problems or filing deficiencies.

v. Audit Log - maintains control records of the status of all audits and financial surveillance reviews by firm, membership category, and by examination number.

vi. Audit Priority Menu - contains information to assist Compliance Department management in the audit scheduling process.

vii. Market Movement - tracks changes in settlement prices for one to ten days for all domestic commodity futures and options.

viii. Daily Telephone Log - maintains financial, segregation and secured amount information reported daily by FCMs for which NFA is the DSRO.

ix. Subordinated Loan Agreements - maintains detailed records on all such agreements filed by FCMs and independent IBs.

x. MRRS Registration Menu - provides access to NFA�s registration database.

xi. Investigations Menu - maintains records of firms, individuals, or customers involved in an investigative matter.

xii. Name Search Menu - permits alphabetic or phonetic searching of customers, firms or individuals, including parties that are not registered or have never been registered with NFA.

The Division reviewed the functioning of each subsystem and affirmed that output information generally was complete and current.

2. Audit Priority System

The audit priority system is used to select members for all types of routine and non-routine audits, and is intended to ensure the most efficient use of audit resources. The audit priority system is structured to take into consideration numerous factors including, but not limited to, the amount of customer funds held, disciplinary history, filing deficiencies, customer complaints and net capital position. Points are assigned to each of the various factors. Member firms that accumulate the most points are given highest audit priority. The priority points are updated automatically and continuously from various files in the FACTS system, as changes are entered into that system. Points can also be assigned and updated by NFA managers and supervisors at their discretion. Points are added or deducted as the circumstances of the firm change. For example, if a firm reduces the number of APs or has fewer accounts under management, its points would be reduced to reflect those changes. If audit priority points have been added to reflect the number of years between audits, those points would be deducted when an audit is completed. There is no minimum number of priority points that trigger an audit; rather, selection for audit depends on a firm�s ranking among all the firms of its type. When an obviously serious problem comes to NFA�s attention, an audit or other appropriate direct contact can be initiated promptly, regardless of the firm's status in the audit priority system.

NFA conducts field audits of its various types of members using several different audit programs. Field audits of FCMs are conducted on both a routine and a "for cause" basis. The routine audits of FCMs alternate annually between full scope audits and limited scope reviews for those FCMs carrying customer funds. An FCM that does not carry customer funds is treated similarly to an independent IB for purposes of NFA�s audit cycle. All routine audits are conducted using NFA�s audit programs that include both financial and sales practice procedures. NFA will conduct additional non-routine audits of FCMs, IBs, branches of IBs, CPOs and CTAs as indicated by the audit priority system.

3. Completion of Survey Questionnaires

Each member FCM, IB, CPO, and CTA is required to complete and return to NFA an annual questionnaire. Additionally, NFA Registration Rule 204(d) states that, on an annual basis, NFA is to provide each FCM, IB, CPO, and CTA a printout of its Form 7-R currently on file. Annually, each member is mailed the questionnaire and registration information update, approximately 45 days prior to the "as of" date for the information on the forms. The member is required to verify the pre-printed information on the questionnaire and Form 7-R, and to provide additional information, as requested. For example, the FCM/IB questionnaire asks the member to provide information about the number of futures and options customer accounts carried, the number of customer accounts managed by the registrant, the number of customer accounts managed by outside parties, use of promotional material, and verification of carrying brokers used by the registrant. Information from returned questionnaires is used to update each member�s record in MRRS and FACTS.

Failure to return the completed questionnaire may ultimately result in NFA scheduling an audit of the registrant. Usually, NFA will increase a firm�s priority point total by five points for failure to return the questionnaire. However, NFA will first attempt to obtain completed questionnaires through mailing a second request or through follow-up telephone calls.

NFA has developed in FACTS, a "Questionnaire Entry" screen to record, for each registrant, the status of each questionnaire since 1990. A questionnaire is considered "unreturned" if after 90 days from the questionnaire as of date, the firm has not returned the questionnaire. After the 90-day period, NFA will determine whether to increase the firm�s priority points or schedule an audit of the non-complying firm.

NFA provided the Division with a listing of 129 firms that had not returned their 1997 questionnaires by December 31, 1997. Fifty-two FCM/IBs, 42 CPOs and 35 CTAs comprised the listing.8

Of the 52 FCM/IBs that had not returned their questionnaires, two firms were FCMs and 50 were IBs. The Division reviewed the audit priority system to determine whether priority points were assigned for failure to return the questionnaire. For the two FCMs that did not return the questionnaire, one FCM had its audit priority point total increased by five points. The other FCM did not receive any priority points for its failure to return the questionnaire.

For the 50 IBs that had not returned the questionnaire, 49 had their audit priority point total increased 5 points for failure to return the questionnaire. The remaining IB did not receive any audit priority points for failure to return the questionnaire.

An NFA representative indicated that the addition of priority points for failure to return the questionnaire is a manual change, not a change done automatically by FACTS. An NFA compliance department staff member must enter the priority points by accessing the priority point subsystem. Apparently, for the two firms that did not receive any priority points for failure to return the questionnaire, the responsible NFA staff member failed to enter the priority points. Neither firm received any priority points for their failure to return their questionnaires.

The Division has been concerned about the large number of firms that have failed to return NFA's questionnaire in a timely fashion. The Division previously noted these concerns in its September 1995 and July 1997 reports on NFA's CPO and CTA Compliance Program. To address the problem, effective March 10, 1998, NFA's Board of Directors amended NFA Bylaws to address the failure to return the annual questionnaire. The revised Bylaw 301(h)viii considers the failure to return the annual questionnaire within 30 days a request for withdrawal of NFA membership. This should significantly reduce the number of questionnaires not returned to NFA, since member firms planning to withdraw their membership and CFTC registration were the prime offenders.

Based upon staff�s review of NFA�s questionnaire tracking system, and in light of NFA's amendment of Bylaw 301(h)viii, it appears that NFA is monitoring its members� compliance in this area.

B. Futures Commission Merchants / Introducing Brokers

1. Daily Financial Surveillance

NFA conducts daily financial surveillance over the FCMs for which it is DSRO. NFA obtains, by telephone or facsimile each day, specific data from each FCM holding customers� funds. FCMs holding customers� funds in the following categories: a) domestic futures and options, b) foreign futures and options, and c) dealer options, report daily. The following is the financial information that each FCM reports to NFA as of the prior business day:

a. Amount of customer funds required to be in segregated accounts.

b. Amount of customer funds actually on deposit in segregated accounts.

c. Amount of customer debits/deficits.

d. Non-customer debit/deficit.

e. Customer open trade equity.

f.����� Proprietary profit or loss.

g. Long option value.

Monthly, NFA obtains each FCM's adjusted net capital as of the prior month-end. For FCMs that are filing monthly financial statements, and during months when quarterly financial statements are due, NFA obtains adjusted net capital by the seventeenth business day of each month from the financial statements that are filed with NFA. For FCMs not required to file monthly financial reports, NFA obtains the adjusted net capital amount, as of the prior month-end, by telephone contact on the first business day of each month. NFA amended their Financial Requirements, Section D2, effective June 30, 1997, to comply with the requirements of Commission Regulation �1.18(b), which requires unaudited financial statements to be filed within 17 business days.

FCMs are required to notify NFA when they begin handling customer accounts.

In addition, each month NFA staff telephones inactive member FCMs to determine whether they have started handling customer business and, therefore, should begin reporting to NFA.

2. High Risk Firms

NFA management decides, on a case-by-case basis, when a member is "high risk", i.e., when a firm should be subjected to close scrutiny. Although it is a matter of judgment, generally a firm will be so designated: 1) if the firm is undercapitalized; 2) if the firm's capital falls below the early warning level; 3) if the firm is undersegregated; 4) if the firm's books and records are not kept current; 5) if the ratio of segregation required to adjusted net capital is greater than 16.67 to 1; 6) if material weaknesses in internal accounting controls are present; or 7) if, in management's discretion, closer scrutiny is required. Firms identified as "high risk" are required to submit on a monthly basis the financial reports that normally are required quarterly. The financial reports are reviewed using the same review procedures as for the financial reports that are filed quarterly. Financial statement notes screens disclose any related follow-up action resulting from the review. In addition, NFA�s follow-up actions may include on-site visits to registrants to monitor the status of any continuing problems and disciplinary action. As of December 31, 1997, NFA identified 15 firms as "high risk." The Division reviewed the FACTS Document Log for the six-month period from June 1997 through December 1997 to determine whether NFA had followed its procedures. The Division�s review disclosed that each of the 15 "high risk" firms had, without exception, filed the required monthly financial reports, for the duration of time in which each of the firms was designated as high risk, and that NFA staff had reviewed those reports.

3. Daily Review of Commodity Price Changes

The FACTS system reviews and reports the prices of all exchange traded commodities on a daily basis. A price movement that exceeds daily limits determined by NFA results in a "management alert." A management alert is disclosed on the FACTS Management Alert system on a daily basis. Price movements are reviewed for their potential effect on FCMs holding large positions in the reported commodity. A follow-up contact is made with any FCM that NFA believes may have suffered material financial exposure due to price fluctuations.

The Division reviewed the daily "Management Control Report(s)" for the period October 1, 1997 through December 31, 1997 and identified commodity price movements reported during the review period. There is evidence of management review for each of the days reporting commodity price movements. Review is documented with the initials of the management reviewer where an item has been reviewed and closed. According to NFA personnel, none of the reported price movements resulted in financial exposure to any FCM, except on October 27, 1997, when a major stock index fell more than seven percent. As a result, NFA closely monitored the trading activities of its member firms. This market break caused substantial losses for two commodity pools and one FCM. However, no FCM failed to meet its financial obligations to customers.

4. Review of Financial Reports

The receipt of timely and accurate financial information is a primary tool of effective regulation, including the monitoring of the financial health of members subject to financial responsibility rules. In this connection, member FCMs and independent IBs are required to file annual certified financial reports prepared in accordance with generally accepted accounting principles ("GAAP") as of their fiscal year-end.9 FCMs file unaudited reports each fiscal quarter, independent IBs file semi-annually, while members considered to be "high risk" are required to file monthly reports.

NFA�s FACTS computerized tracking system generates letters reminding members when financial reports and other documents are due to be filed. NFA staff follows up with telephone calls if documents are not received. The financial analysis subsystem performs financial statement analysis functions and stores key financial information. All financial reports received are assigned to a staff analyst for review. Whenever a statement is determined by NFA to have been materially misstated, the member at a minimum is required to file an amended report. The system also ages all financial reports from the date received in accordance with Division Interpretation No. 4-1. This system tracks financial reports, e.g., Forms 1-FR and annual certified financial statements, starting from the date the report is received until the date the report is closed.

The Division selected for review a sample of twelve financial reports filed with NFA. The sample was comprised of three certified financial reports and nine Forms 1-FR. The Division determined that, when NFA found errors in the financial reports, corrected financial reports were required.

The Division also reviews, on an ongoing basis, the same financial reports that firms file with NFA. A comparison was made of the results of the Division�s review and NFA�s review of the sampled financial reports. The comparison of review results and conclusions did not disclose any differences in the Division's and NFA's reviews. Because the Division does ongoing reviews of identical financial reports as NFA, and the results of both reviews are similar, the Division determined to limit its examination of NFA�s financial statement reviews to the initial sample of 12 financial statements.

The Division concluded that NFA took prompt action whenever financial reports indicated a problem, and that NFA has enforced the requirement that its members file timely and accurate financial reports.

5. On-Site Audits

The Division reviewed NFA�s execution of its in-field audits of FCMs, independent IBs ("IBIs"), guaranteed IBs ("IBGs"), and branch offices. The Division also reviewed NFA�s sales practice program for exchange-member FCMs in connection with commodity futures trades where a commodity exchange is the DSRO for financial surveillance, but limits sales practice surveillance to commodity options.10 Effective July 1,1998, sales practice audits for both futures and options compliance are being conducted by the commodity exchanges, unless such auditing has been contracted to NFA.

The purpose of this review was to evaluate NFA�s compliance with Interpretation No. 4-1 regarding its in-field audit program.11 The review covered the adequacy of NFA�s audit coverage, the timeliness of NFA audits, NFA's diligence in identifying rule violations and timely reporting material problems in internal controls and accounting systems to the Division, and the effectiveness and propriety of NFA's closure actions.

The Division utilized its SRO Review Program for In-Field Examinations in carrying out its review. The purpose of this Program is to determine, by a review of audit working papers, that there is documentation for the scope setting process; that the audit work is thorough and documented; that the auditors followed the written program; that there is sufficient evidence to support the audit�s findings; and that all material questionable items were investigated and resolved.

NFA conducts biennial full scope financial/sales practice examinations and off- year limited scope examinations of FCMs holding customers� commodity funds for which it has been assigned DSRO responsibility by the JAC.12 Audits of FCMs carrying customers� commodity funds are done on a surprise basis. The FCMs are not contacted or otherwise advised of NFA�s planned audit prior to NFA auditors' first appearance at the FCM. The purpose is to permit the auditors to verify that FCM books and records are being maintained on a current basis.

For audit selection purposes, FCMs that carry no customer funds are treated as the functional equivalent of IBs under NFA�s audit priority system. Only after the FCM begins carrying customers� commodity funds will NFA include the FCM in its biennial audit schedule. Through its daily monitoring of FCMs, NFA is able to identify when an FCM begins carrying customers� commodity funds. An FCM is scheduled for an audit within three months after it begins carrying customers� commodity funds.

Member firms that are registered in more than one capacity are audited by NFA for compliance with rules affecting all such membership categories. During audit scope determination, NFA identifies the registration categories under which a member is registered, and determines the audit programs needed to audit that member.

NFA submits its updated audit programs annually to the Division. The Division reviews the programs to ensure that they address all significant regulatory requirements that must be verified during the field audit process, including both the financial and sales practice areas.

a. Audit Coverage

The audit coverage of FCM member firms is significantly greater than that of member IBs due to Interpretation No. 4-1, which requires NFA to audit FCMs holding customer funds annually and permits IBs to be audited on a "for cause" basis. Furthermore, the number of member IBGs for which NFA is DSRO is reduced by the number of IBGs guaranteed by FCMs that have a commodity exchange as their DSRO since the FCM�s respective DSRO is responsible for auditing those IBGs. NFA�s IB DSRO audit responsibility is also reduced by the number of inactive IBGs and IBIs for which it is DSRO.

As of July 1998, NFA had 1,157 member IBGs, of which FCMs guaranteed 976 subject to a commodity exchange DSRO, and 68 subject to NFA as DSRO were inactive. Consequently, NFA was DSRO for 113 active IBGs of which 39, or 34%, were audited during the first seven months of 1998. In the case of IBIs, NFA had 384 members, of which approximately 250 were active and of which 73, or 29%, were audited during the same period. NFA does not routinely capture this data; it must be manually compiled. Therefore, similar statistics for prior years were not readily available. However, NFA is able to compile such data on a current basis upon request by the Division.

Number of NFA Audits and Number of Member FCMs and IBs

* - This is the number of FCMs carrying customer funds and the number of audits of those firms.

b. Timeliness of Audits

The Division reviewed NFA�s audit priority system and audit logs of routine field audits to determine whether members who should be audited were audited in a timely manner and that the frequency of audits was in conformity with the standards set forth in Interpretation No. 4-1. The Division compiled a list of FCMs holding customer funds as of December 31, 1997, based on data obtained from CFTC regional offices. The FACTS Audit Log was queried for each FCM to determine whether NFA conducted at least one full scope audit of each FCM within the past two calendar years. The Division also reviewed NFA�s audit reports and workpapers to determine whether the audit programs were, in fact, appropriately executed, completed, and closed with appropriate action taken. The Division�s review found that FCMs were audited in accordance with the schedule in Interpretation No. 4-1 and that the programs were carried out appropriately.

In September 1997, NFA informed the Commission of intended changes to its audit scheduling guidelines.14 The revised guidelines establish a cycle for conducting audits of the various registration (membership) categories, as follows:

FCMs carrying customer accounts - audited every year;

"Highest Priority" registrants (those at the very top of priority list) - audited at least every other year;

Newly active registrants (members) - 75% audited within one year of NFA's learning that they are active and the remaining members audited within two years;

Previously audited registrants - 50% on a three-year cycle; 75% on a four-year cycle; and 100% within five years of the previous audit. (Registrants whose only customers are Qualified Eligible Clients or Qualified Eligible Participants15 will be audited within seven years.)

c. FCM Audits During Sample Period

The Division sampled nineteen FCM audits for this review, eleven by NFA's Chicago office and eight by NFA's New York office. An original random sample was made of all FCMs. However, only ten of the firms in that random sample carried customer funds. Therefore, Division staff selected six other firms that did carry customer funds. A third sample of three audits was selected after Division auditors reviewed all FCM audit reports issued in 1997 and through June 1998.

The scope of the full scope audit is determined after taking into consideration all information available on the firm. In four full scope FCM audits, NFA did not complete all of the modules in the full scope audit. Based on NFA�s risk-based scope setting process, completion of all modules is not necessary. In four of the audits, the module on order processing was not completed; in three, the module on records was not completed; in two, the module on block orders; in one, the module on affiliates; and, in another, the module on supervision was not completed. In each case, the workpapers documented that the modules were not completed because no problems had been found in those areas in the recent examination(s) of the firm. For purposes of this review, Division auditors did not verify NFA�s statements by reference to prior audit workpapers. Division staff did review NFA�s risk-based scope setting process in light of the audit work performed. The Division concluded that NFA�s scope setting process was consistent with the concept of risk-based auditing, since NFA is taking into consideration all information available on the firm but is not completing modules where there does not appear to be a risk of deficiencies.

Division auditors reviewed audits performed on one firm in consecutive years, 1997 and 1998. There were four findings noted in the 1998 audit that were repeat findings from the 1997 audit: the firm included error accounts16 in the amounts to be segregated; the firm did not calculate debit/deficits on a daily basis; the firm established a segregated bank account outside the United States with a bank that is not a depository recognized by the CFTC; and the firm allowed a customer to place trades other than for risk reduction even though his account was in debit and undermargined.

In all four findings in the 1997 audit the firm responded that they would take corrective action. NFA's letter to the firm indicated that as long as the firm represented that it would take the corrective action, no response to NFA�s letter was needed. In the 1998 audit, after being cited for the same deficiencies, the firm represented that they would take corrective action. NFA again accepted this response and said that no response to their letter was needed since the firm represented that they would take action.

In light of the fact that the firm had already failed to correct these four items, as evidenced by the fact that they were cited again in the 1998 audit, it appears that NFA should take stronger action and require a firm, in these instances, to submit verification that they have taken the corrective action before closing the audit. At a minimum, when there are repeat findings, NFA should require the firm to respond to the audit report in writing to document the steps that have been taken to correct the deficiencies.

This approach was taken by NFA with respect to another FCM that failed to address prior problems by the time of a subsequent NFA audit. In this case, NFA advised the FCM to submit a written response addressing the corrective action for each finding and addressing NFA�s proposal to recommend to the Business Conduct Committee that a complaint be issued against the FCM. The FCM submitted a written response to NFA with their proposed corrective action for each finding and requested a meeting with NFA to discuss the findings, since NFA advised the firm that the matter may be referred to the BCC.17

d. IB Audits During Sample Period

The Division sampled nine independent IB and four guaranteed IB audits for this review. Division staff found only one exception. A guaranteed IB audit in the sample included a repeat violation by the IB of accepting customer checks in the name of the IB, not the FCM. In their workpapers, NFA noted that firm personnel agreed to request written relief from CFTC on the issue. NFA staff indicated that they were going to follow up in the next audit of the firm to determine whether the letter had been written as indicated. The firm requested relief in a letter to the CFTC dated July 17, 1998, eleven months after the close of the audit.

e. Branch Office Audits During Sample Period

The Division sampled thirteen branch office audits for this review.18 Overall, the workpapers and written reports contained sufficient documentation. However, in one audit in this sample, the workpapers did not contain the firm�s response and corrective action taken for one of the findings. Upon follow-up by the Division, NFA provided the firm�s response and indicated that apparently the audit team did not properly save the file when they entered the firm�s response. Since this was an isolated instance, the Division is not making any recommendation for corrective action by NFA.

f. Audit Workpapers

Copies of computerized audit workpapers are readily available to the Division. NFA is able to make copies on diskette of the audit workpapers from their in-house computer system upon request from the Division. The only delay in receiving workpapers occurs when related paper or source documents are not on site at NFA and must be retrieved from storage. Source documents include such items as copies of promotional material, firm records, and confirmations. Division auditors review source documents when reviewing NFA audit workpapers.

6. Guarantee Agreements

Introducing brokers that are party to a guarantee agreement with an FCM are subject to the requirements of CFTC Regulation 1.10(j). A guarantee agreement relieves the IB of having to comply with the Commission�s $30,000 minimum net capital requirement. A guarantee agreement subjects the IB and FCM to joint and several liability in connection with customer complaints. NFA Registration Rule 204(c)(2) provides for withdrawal of registration for failure to comply with CFTC Regulation 1.10(j). The withdrawal will be effective 30 days after termination of the guarantee agreement unless the IB enters into a new guarantee agreement or complies with the net capital requirements. NFA�s on-site audit modules for both FCM and IB audits include procedures to ensure that guarantee agreements are filed with NFA. The Division�s review of its sample of FCM and IB audits confirmed that guarantee agreements were in place in all the audits sampled.

7. Sales Practice

NFA�s rule enforcement program includes sales practice field audits of FCMs and IBs, which examine the registrants� practices in soliciting customer commodity futures and options accounts. The books and records reviewed include: customer orders; customer confirmations and other account statements; records regarding the handling of discretionary accounts; disclosure documents; advertising and other promotional material; customer complaints; and records relative to the internal supervision of account executives and other order handling or sales personnel. Sales practice audits are part of NFA�s full scope audits or may be performed separately on a "for cause" basis.

The Division�s staff, during its current review, examined reports and conducted reviews of the respective audit files and workpapers of 36 audits completed by NFA. The staff specifically reviewed NFA audits of 16 FCMs, 9 IBs and 11 branch offices. As described below, the results of these reviews indicated that NFA�s program appeared to be effective in this area.

a. FCMs

NFA continues to update its written guidelines for conducting compliance examinations of its member FCMs and IBs. The current review found that NFA�s sales practice audit guidelines are comprehensive and adequate to guide auditors conducting in-field audits. NFA�s current guidelines for FCM and IB audits include the following modules relating to sales practices:

Module Description

Division staff reviewed the audit files and workpapers of sixteen FCM audits. The review of the audits indicated that the audit guidelines and procedures developed by NFA generally were being followed, that supervisors reviewed the supporting workpapers, and that the necessary follow-up was completed by NFA.

b. IBIs and IBGs

The Division�s review also included a review of the sales practice related workpapers on five IBI and four IBG audits. The Division found that NFA auditors followed the written audit programs for the respective IBI and IBG audits and that all sections of the program for those audits that were subject to an in-depth review were completed with supporting workpapers.

c. Branch Offices of FCMs, IBIs, and IBGs

NFA has direct sales practice audit responsibility for branch offices of FCMs and IBIs. NFA also has responsibility for IBGs which are guaranteed by FCMs for which NFA is the DSRO. The Division�s review of five FCM branch audits, two IBI branch audits and four IBG branch audits disclosed that NFA�s branch office audit coverage appears adequate. In this connection, the Division found no instances of a branch not being subject to an audit where factors such as customer complaints or findings in the FCM�s full scope audit indicated that a branch on-site audit appeared warranted. NFA�s priority system and close monitoring of customer complaints appear to ensure branch office audit coverage of any office experiencing possible sales practice related problems.

d. Customer Complaints

The Division, during the current review, evaluated NFA's handling and disposition of customer complaints for the period January 1, 1996, through June 30, 1998. Review of complaints is an integral part of the Division�s oversight program of all SROs and is especially important at NFA because of NFA�s status as a registered futures association. Section 17 of the Commodity Exchange Act, as amended, requires a registered futures association to establish and enforce minimum standards for sales practices of its members and to provide a fair and equitable procedure for the settlement of customer claims or grievances. Since being designated as a registered futures association, NFA has adopted numerous sales practice rules designed to protect the retail customer. The Division has found that the review and follow-up of complaints received is the single most important component of NFA�s sales practice program. How well NFA has addressed the complaints it receives is probably the single most important criteria for evaluating the success of NFA�s efforts to enforce its rules. As explained below, the Division found no deficiencies in the NFA program for processing and investigating customer complaints.

The Division requested that NFA provide all customer complaints received by NFA for the period January 1, 1996 through June 30, 1998. NFA provided the Division with computer runs, which showed that NFA received 71 complaints in 1996, 94 complaints in 1997, and 51 complaints for the period January 1, 1998, through June 30, 1998. The Division reviewed all complaints and selected as samples years 1996 and 1998 for the purpose of identifying numerous complaints or a pattern of complaints against any registrant, which should have caused NFA to consider further action. The Division found no multiple complaints against any firm or AP of the 51 complaints received between January 1 and June 30, 1998. NFA, upon investigation of the subject matter of the complaints, noted in seven instances that further review of the complaint and a review of complaints received directly by the firm would be completed on-site at a scheduled audit. The Division tested 3 of those proposed actions and found that NFA had completed the additional review as part of the audits. In 1996 there were three firms that did have multiple complaints, one FCM and two IBs. The Division found in all instances that NFA had noted in the complaint files that NFA already had open investigations of the firm and that the complaints would be considered as part of the ongoing investigations. NFA ultimately took disciplinary action against all three firms for sales practice related violations and all of the firms are closed. The Division found that NFA had used customer complaints received as well as on-site audit findings as integral parts of these investigations.

The Division also verified, on a random basis, any stated referrals to the CFTC, other SROs or appropriate agencies, such as state regulatory officials, thus no follow-up action other than consideration of adding priority points for receipt of the complaint, as per NFA procedures, was required.

The Division found that NFA�s procedures for recording and investigating customer complaints are adequate and that the reviews are completed in a timely manner. All complaints are reviewed by the Chicago compliance department staff, in most cases by the same staff that conducts field audits, thus NFA staff is often already familiar with a firm and its procedures. The Division found that NFA appeared to review all relevant facts of all complaints and found no instances where the Division believed that NFA failed to address the relevant facts contained in the complaint. NFA provides to each customer information on NFA arbitration as well as alternative remedies such as the Commission�s reparation program. The Division also found that information on complaints contained in NFA's FACTS database, which is accessible to both NFA audit staff and other SROs, is a useful compliance tool for monitoring sales practice activities both of firms and individual registrants.

C. Disciplinary Actions

The compliance department initiates disciplinary actions taken by NFA. If apparent violations are found, usually during an audit, a summary of the findings is prepared and a formal investigative report is drafted by the Legal Department and presented to the Business Conduct Committee ("BCC"). After receipt of the investigative report and review of the facts and the severity of the allegations, the BCC may proceed in one of three ways. If the violation is deemed not material, the BCC does not believe there is sufficient evidence to prove the alleged violation, or there are extenuating or mitigating circumstances which contributed to the apparent violation, the BCC may close the case by instructing the compliance department staff to issue a warning letter. If the BCC believes that the violation merits a more severe action than a staff warning letter, but believes that the matter does not require formal disciplinary action, the BCC itself may issue a formal warning letter to the firm and close the matter. Finally, if the BCC believes that there have been material violations, it may commence a formal disciplinary action.

Most NFA disciplinary actions begin with the BCC reviewing the summary of the compliance department findings and recommendations, and issuing a formal complaint. The complaint contains instructions on filing an answer to the complaint and procedures for requesting a hearing, under NFA Rule 3-2, on the allegations contained in the complaint. Normally the respondent is given 30 days to file an answer and/or request a hearing with the BCC. Failure to file an answer to the complaint is deemed under NFA rules to be an admission of the facts and a waiver of the respondent's right to a hearing.

NFA initiated thirty-seven disciplinary actions during the 1996-1997 period reviewed. There were fifteen cases for sales practice violations, thirteen for fraud and related matters, and nine for failure to meet financial requirements. Neither the Division�s review of NFA audit reports nor NFA staff �s recollection disclosed any instance where BCC did not support NFA staff taking disciplinary action where material apparent violations were disclosed.

NFA BCC ACTIONS 1996 & 1997

D. Member Responsibility Actions

NFA took Member Responsibility Actions ("MRAs") in nine instances during the review period. MRAs are immediate actions taken by NFA�s President, on the recommendation of NFA staff, to protect customer funds. These actions often involve capital violations or deficiencies, or instances where NFA believes that customers� funds would be in jeopardy if immediate action is not taken.

MEMBER RESPONSIBILITY ACTIONS

1996 &1997

VII. CONCLUSION

The Division concluded that NFA's design and execution of its financial and sales practice compliance program for FCMs and IBs complies with applicable regulatory standards. Audit findings were adequately documented in NFA's audit reports and workpapers, and the overall quality of the audit workpapers in documenting the execution of the program was generally good. The Division has no major recommendations for enhancement of NFA's Program.