Forex IB’s Need Disclosure Documents; Offering Memorandum’s

Your firm has finally decided to become a CFTC registered, NFA member forex broker (“IB”) or money manager (“CTA” or “CPO”).  Congratulations, I salute you for making the right choice, but now what?  It should come as no surprise that your firm will now have to adhere to a plethora of regulatory requirements, but are you prepared?  To further educate you about your obligations as a regulated company let’s take some time to discuss a largely misunderstood NFA compliance rule that could greatly affect your business.

NFA Compliance Rule 2-41

NFA compliance rule 2-41 was put on the books in November of 2008 and became effective as of December 8^th, 2008.  Since that time there has been little written on this rule and the word on the street is that enforcement efforts related to it will be stepped up heavily during 2010.  Assuming this rule will be pushed to the forefront of regulation during the next year what can your firm do to prepare?  As with all regulatory obligations one must first understand what is required to comply with a rule so let’s start there.  Briefly NFA Rule 2-41 states the following for most forex firms:

Forex Pool Operators & Funds- Are required to prepare a disclosure document and file it with NFA 21 days prior to soliciting the funds first potential pool participant.  This document must then be supplied to the client prior to them receiving an account subscription agreement and depositing funds to a pool.  In addition if a firm will trade futures and forex products or just forex products, 2-41 requires very specific risk disclaimers.

Trading Advisors- Are required to prepare a disclosure document and file it with NFA 21 days prior to soliciting the first potential pool participant.  This document must then be supplied to the client prior to them receiving the subscription agreement and determining to follow a specific trading strategy.  In other words, before an advisor can take discretion over an account and guide client trading a disclosure document must be provided.  This disclosure document must be written in nearly an identical fashion to documents required for on-exchange traded products under CFTC 4.34, 4.35, and 4.36.  Also, just as with fund managers, in this instance a specific risk disclosure related to discretionary forex trading is required.

What this Means for Forex IB’s and CTA’s

If your forex firm is currently registered as a CTA or CPO then this rule probably isn’t that surprising to you.  However, if your company is registered as an IB you may be in for quite the shock.  Notice above that I said “Trading Advisors” not CTA’s or CPO’s; I wrote this intentionally because of the way the rule is written.  Based on the language included in 2-41, depending on a firms unique business circumstances, it is possible that introducing brokers may be required to prepare a disclosure document for their customers.  If this is the case for your company not having supplied a disclosure document to clients, or even worse, not having a document prepared altogether could be disastrous to your business operations.  Now that you know you may need such a document, the next question your firm should be asking is: “How can we determine if we are required to write and provide a disclosure document to our customers?”

Determining your Obligation

I have put together the following guidelines to help your firm in its attempts to determine if a disclosure document is needed.  When reading this list please keep in mind that all brokerages have very specific and unique business circumstances.  As a result this simple process should only be used as a tool to determine your potential obligations under NFA Rule 2-41.  If you have any doubts about your obligations you should seek proper advice from a regulatory professional.

Step 1:  Your company must first determine if its clients would be considered eligible contract participants or “ECP’s” as defined by the Commodity Exchange Act’s Section 1a (12).  In almost all retail forex circumstances the accounts you’ll be handling will not qualify as ECP’s.  Thus, for most reading this article it would be wise to move on to step two.  More specifically if you trade with ECP’s you probably are already well aware of the fact that they are qualified as such.

Step 2:  Evaluate the business model utilized by your brokerage.  Does your firm take discretion over customer trades?  Do your accounts trade in a self directed manner?  Do you promote an electronic trading strategy and require a power of attorney or letter of direction to execute trade signals on a client’s behalf?  The answer to these questions should give you more insight into whether or not you will need a disclosure document.  Generally, if you are taking discretion over client accounts and making all or the majority of trading decisions on behalf of your clients you will likely need a disclosure document.  If your accounts are self directed it is likely you will not be considered a trading advisor in the context of Rule 2-41.  Evaluating the mechanics of how electronic trading systems operate is difficult.  In my opinion there is no hard and fast way to know for certain if this type of trading would require a disclosure document.  In order to determine your obligation in this instance it would be best to hold a detailed discussion of such a system with a regulatory professional.

Step 3:  Consider how your company is being compensated by its FDM and/or its clients on account activity.  Are you paid a standard pip rebate or commission on the forex transactions running through your business?  Are you paid some type of variable performance or management fee?  The answer to these questions when considered in conjunction with step 2 above are critical to whether or not your business will need a disclosure document.  Generally when a performance or management fee is paid it is a good sign that you are operating in a manner that will require additional disclosure under 2-41. Conversely, if your firm is being paid strictly on a transactional basis and is making no trade decisions for customers it is less likely that it will be required to produce further disclosure.

Finding out for Sure, What to do if a Disclosure Document is needed

If it appears your firm will need a disclosure document or if you are unsure about your company’s obligations, what is the next step?  The next step is that your firm should contact a regulatory professional to further assist in evaluating your unique business situation.  Seeking professional help in this matter will be the only option if your firm is unable to determine its requirement under rule 2-41 on by itself.  Seeking council from NFA could be an option; however they will not be able to further assist you in the creation of a document if your company does in fact need one.  As a result your business will likely end up requiring private regulatory assistance at some point anyhow so starting there just makes the most sense.

When looking for a regulatory professional it is critical to understand that the forex trading community operates in a manner which is drastically different from that of the futures and or securities market spaces.  The forex industry is evolving almost on a daily basis, many of the rules are slightly more than a year old, and not that many firms are familiar with them.  I mention this because standard service providers are likely to improperly guide you if they apply futures and securities specific rules and regulations to your unique forex questions.  Therefore, unless you’re willing to become a guinea pig, it is imperative that you utilize a firm that is familiar with all of NFA’s forex rules.  A misstep in the way of improper customer disclosure could be devastating to your business and if the rumors are true, 2010 could bring about a very painful and long year dealing with the CFTC and NFA.

James Bibbings is the President and CEO of Turnkey Trading Partners (“TTP”), a firm that supports all commodity and forex specific regulatory and business needs. Prior to founding TTP, Bibbings worked with the National Futures Association (“NFA”) as a supervising auditor. During his time with NFA he was involved in over 100 investigative audits and was able to gain a deep working knowledge of FDM, FCM, IB, CTA, and CPO operations.  Bibbings has provided financial markets content for MSN, Yahoo, FinAlternatives, Wiki-Investments, Safe Haven, Financial Sense, Market Watch, Commodity News Center and many other highly acclaimed investment publications.  He has also authored two highly sought after informational pamphlets regarding futures and forex registration which are available for free upon request through his company website.  If you have any questions or comments for Bibbings he can be reached directly by email at james@turnkeytradingpartners.com and would love to hear from you.