# Amendments to Commodity Pool Operator and Commodity Trading Advisor Disclosure Rules > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A95-17871 ## Record - **Collection:** Federal Register - **Document type:** Rule - **Published:** July 25, 1995 - **Citation:** 60 FR 38146 ## Text SUMMARY: The Commodity Futures Trading Commission (``Commission'') is announcing the adoption of substantial revisions to the disclosure framework applicable to commodity pool operators (``CPOs'') and commodity trading advisors (``CTAs''). These amendments are intended to achieve greater simplicity, focus and clarity in performance history; to streamline other required disclosures; to improve the presentation and understandability of disclosures to investors; and to create a more concise and readable format for Disclosure Documents. EFFECTIVE DATE: August 24, 1995. FOR FURTHER INFORMATION CONTACT: Susan C. Ervin, Deputy Director/Chief Counsel, Barbara Stern Gold, Assistant Chief Counsel, or Christopher W. Cummings, Attorney/Advisor, Division of Trading and Markets, Commodity Futures Trading Commission, 2033 K Street, NW., Washington, DC 20581. Telephone: (202) 254-8955. SUPPLEMENTARY INFORMATION: Table of Contents I. Background A. Development of Proposed Part 4 Revisions B. National Futures Association Proposals C. April 25, 1995 Roundtable Discussion D. Review of Public Comments II. Transitional Provisions III. Summary of Rule Changes A. Definitions B. Required Performance Disclosures C. Required Non-Performance Disclosures D. Non-Required Disclosures E. Format Improvements to Enhance Readability F. Other Revisions G. Distribution Table IV. Definitions A. Major Commodity Trading Advisor: Rule 4.10(i) B. Major Investee Pool: Rule 4.10(d)(5) C. Multi-Advisor Pool: Rule 4.10(d)(2) D. Principal-Protected Pool: Rule 4.10(d)(3) E. Trading Manager: Rule 4.10(h) F. Trading Principal: Rule 4.10(e)(2) G. Break-Even Point: Rule 4.10(j) H. Draw-Down and Worst Peak-To-Valley Draw-Down: Rules 4.10(k) and (l) V. Performance Disclosures: Section-by-Section Analysis A. Introduction B. Required Performance Disclosures 1. Required Performance Disclosures in CPO Disclosure Documents: Rule 4.25 a. Capsule Performance Presentation: Rule 4.25(a)(1) b. Pools With Three or More Years Operating History that Meet Contribution Criteria: Rule 4.25(b) c. Pools With Less Than A Three-Year Operating History: Rule 4.25(c) 2. Required Past Performance Disclosure in CTA Disclosure Documents: Rule 4.35 3. Time Period for Which Required Past Performance Disclosure Must Be Made: Rules 4.25(a)(5) for CPOs and 4.35(a)(5) for CTAs 4. Composite Performance Presentations: Rules 4.25 (a)(3) and (a)(4) for CPOs and Rule 4.35(a)(3) for CTAs a. CPO Disclosure Documents b. CTA Disclosure Documents c. Substantiating Composite Presentations 5. Order of Required Performance Disclosures: Rules 4.25(a)(2), (a)(3)(i) and (a)(3)(ii) for CPOs and 4.35 (a)(1) and (a)(2) for CTAs 6. Required Performance Legends a. Legends Relating to Lack of Trading Experience: Rules 4.25(c) for CPOs and 4.35(b) for CTAs b. Legends Relating to Predictive Value of Past Performance: Rules 4.25(a)(9) for CPOs and 4.35(a)(8) for CTAs 7. Summary Tables a. Performance Disclosure Requirements b. Sample Capsule Performance Presentations c. Sample Bar Chart/Graph of Monthly Rates of Return C. Non-Required Performance Disclosures 1. Voluntary and Supplemental Performance Disclosures: Rules 4.24(v) for CPOs and 4.34(n) for CTAs 2. Proprietary Trading Results: Rules 4.25(a)(8) for CPOs and 4.35(a)(7) for CTAs 3. Pro-Forma, Hypothetical and Extracted Performance Results VI. Non-Performance Disclosures: Section-by-Section Analysis A. Introduction 1. Disclosures Concerning a Pool's CTAs 2. Disclosures Concerning Investee Pools B. Required Non-Performance Disclosures 1. Prescribed Non-Performance Statements, Table of Contents and Forepart Information: Rules 4.24 (a) through (d) for CPOs and 4.34 (a) through (d) for CTAs a. Cautionary Statement b. Risk Disclosure Statement c. Table of Contents d. Information To Be Included in Forepart e. Persons To Be Identified 2. Business Background: Rules 4.24(f) for CPOs and 4.34(f) for CTAs 3. Principal Risk Factors: Rules 4.24(g) for CPOs and 4.34(g) for CTAs 4. Investment Program and Use of Proceeds: Rule 4.24(h) for CPOs 5. Fees and Expenses; ``Break-even'' Analysis: Rules 4.24(i) for CPOs and 4.34(i) for CTAs 6. Conflicts of Interest: Rules 4.24(j) for CPOs and 4.34(j) for CTAs; Related Party Transactions: Rule 4.24(k) for CPOs a. Conflicts of Interests--CPOs b. Conflicts of Interests--CTAs c. Related Party Transactions 7. Litigation: Rules 4.24(l) for CPOs and 4.34(k) for CTAs 8. Principal-Protected Pools: Rule 4.24(o) for CPOs C. Supplemental and Voluntary Disclosures: Rules 4.24(v) for CPOs and 4.34(m) for CTAs VII. Other Changes A. Deletion of Negative Disclosures B. Use, Amendment and Filing of Disclosure Documents: Rules 4.26 for CPOs and 4.36 for CTAs C. Disclosure Document Delivery Requirements 1. Notice of Intended Offering and Term Sheet 2. Acknowledgment of Disclosure Document D. Conforming Changes VIII. Related Matters A. Regulatory Flexibility Act B. Paperwork Reduction Act I. Background A. Development of Proposed Part 4 Revisions On May 5, 1994, the Commission proposed comprehensive revisions to the disclosure framework for CPOs and CTAs (``Proposing Release'').\1\ This proposal followed more than fifteen years of experience in administering the part 4 disclosure framework and reflected a comprehensive review of the disclosure requirements for CPOs and CTAs designed to identify aspects of the regulatory structure that could be streamlined or simplified, while enhancing appropriate customer protection. The first phase of this review resulted in the adoption of Rules 4.7 and 4.8 in 1992.\2\ The adoption of the rules set forth herein is part of the second phase of the Commission's review of part 4.\3\ As the Commission [[Page 38147]] stated in the Proposing Release, the purposes of these revisions are: (1) Simplification of past performance disclosures; (2) reduction of required disclosures concerning matters of secondary relevance; and (3) clarification and modernization of various requirements.\4\ \1\ 59 FR 25351 (May 16, 1994). The initial sixty-day period for public comment on the Proposing Release expired on July 15, 1994 but was extended to August 17, 1994. The proposed amendments included conforming changes to other rules, e.g., to Rule 30.6, which pertains to disclosures required of CPOs and CTAs offering pools or accounts, respectively, to trade in foreign futures contracts as defined in Rule 30.1. 59 FR 37189 (July 21, 1994). The Commission's rules governing the operations of CPOs and CTAs are set forth in part 4 of the Commission's regulations, 17 CFR part 4 (1994). All other Commission rules referred to herein are found at 17 CFR Ch. I (1994). \2\ Rule 4.7 provides relief from certain disclosure, reporting and recordkeeping requirements applicable to CPOs for pools offered and sold only to ``qualified eligible participants'' and CTAs providing commodity interest trading advice to ``qualified eligible clients,'' as defined therein, and who satisfy other specified criteria for relief. Rule 4.8 provides relief from the twenty-one day Disclosure Document pre-filing requirement (now contained in new Rule 4.26(d)(1)) for CPOs of certain privately-offered pools. \3\ This second phase will also consider, in consultation with the Securities and Exchange Commission and the states, the appropriateness of a two-part format for pool Disclousre documents. See 59 FR 25351. \4\ 59 FR 25351. These revisions do not, however, affect the basic organizational structure of part 4. Thus, the subparts thereunder continue to apply as follows: subpart A, to definitions and exemptions (Rule 4.1 et seq.); subpart B, to the operations and activities of CPOs (Rule 4.20 et seq.); subpart C, to the operations and activities of CTAs (Rule 4.30 et seq.); and subpart D, to advertising (Rule 4.40 et seq.). --------------------------------------------------------------------------- In announcing the adoption of part 4 in 1979, the Commission stated that the Disclosure Document requirement for CPOs was intended ``to protect pool participants--particularly those who are unsophisticated in financial matters--by ensuring that they are informed about the material facts regarding the pool before they commit their funds.'' \5\ Similarly, the Disclosure Document requirement for CTAs was premised, in part, upon the view that ``a prospective (CTA) client or subscriber should be aware of the advisor's commodity and general business experience if he is to make an informed decision as to whether or not to avail himself of the advisor's services.'' \6\ \5\ 44 FR 1918, 1920 (January 8, 1979). \6\ 42 FR 9278, 9279 (February 15, 1977). --------------------------------------------------------------------------- In the Proposing Release, the Commission noted that since the original adoption of the part 4 rules, the number of registered CPOs had more than doubled and the number of CTAs had increased nearly threefold; \7\ assets under the management of CPOs had grown dramatically; \8\ and the range of available futures and option contracts had increased substantially.\9\ In addition, during the past decade, trading structures and investment portfolios have become increasingly diverse and complex. A single commodity pool may engage multiple CTAs and invest in multiple commodity pools (``investee pools'') \10\ or securities funds in order to access the services of particular traders or advisors, employ multiple trading strategies or programs, or diversify its portfolio.\11\ Further, commodity pools frequently retain ``trading managers'' to recommend or select CTAs to manage, or funds in which to invest, the pool's assets \12\ and may employ dynamic asset allocation strategies entailing periodic replacement of, or reallocation of assets among, CTAs for the pool. \7\ 59 FR 25351, 25352 and n.7. \8\ 59 FR 25351, 25352 and n.8. \9\ 59 FR 25351, 25352 and n.9. \10\ Rule 4.10(d)(4) defines the term ``investee pool,'' discussed more fully below. \11\ 59 FR 25351, 25353 and n.11. \12\ 59 FR 25351, 25353. Rule 4.10(h) defines the term ``trading manager,'' as discussed more fully below. In implementing its statutory mandate to regulate the activities of CPOs and CTAs, the Commission has endeavored to refine its rules as appropriate to respond to changing market conditions in a manner consistent with customer protection.\13\ The Commission's Division of Trading and Markets (``Division'') has issued relief on a case-by-case basis to facilitate application of the disclosure requirements to new market conditions not contemplated by the existing regulatory framework, such as multi-advisor and fund-of-funds structures. The objective in such cases is to apply the rules so as to foster clear and succinct disclosure of material information, especially concerning fees and other aspects of fund operations affected by such structures, taking into account the particular characteristics of the offered investment vehicle.\14\ In many cases, strict application of existing disclosure requirements to pools whose CPOs have voluminous performance histories or which invest through multiple CTAs or investee funds could result in undue emphasis upon performance record disclosure and reduced focus upon more germane data. These effects have been mitigated in appropriate circumstances through grants of exemptive or no-action relief.\15\ \13\ See, e.g., Rules 4.5, 4.12(b) and 4.7, adopted in 1985, 1987 and 1992, respectively, and the discussion of those rules at 59 FR 25351, 25353. \14\ 59 FR 25351, 25353-25354. In reviewing Disclosure Documents for fund-of-funds structures, Division comment letters previously have stated that although pool documents should provide all information required by (former) Rule 4.21 for each investee pool, ``generally at the same level of detail as though the investee pool were providing its own separate disclosure document,'' nevertheless reduced disclosures are appropriate where less than twenty-five percent of the assets of the offered pool would be invested in an investee pool. The Division has also provided guidance through interpretative statements and advisories with respect to past performance presentations in Disclosure Documents. See, e.g., CFTC Advisory 87-2, (1986-1987 Transfer Binder) Comm. Fut. L. Rep. (CCH) para. 23, 624 (June 2, 1987), defining the term ``beginning net asset value'' for rate of return calculations; CFTC Advisory (unnumbered, dated February 27, 1991), (1990-1992 Transfer Binder) Comm. Fut. L. Rep. (CCH) para. 25,005, permitting CPOs and CTAs to use alternative rate of return computation methods to more accurately reflect the return on funds available for trading during the period; and CFTC Advisory 93-13, [Current Transfer Binder] Comm. Fut. L. Rep. (CCH) para. 25,554 (February 12, 1993), permitting the use of an alternative method for computing CTAs' rates of return. As noted below (see n.15), the staff addresses specific requests for relief on a case-by-case basis. \15\ See, e.g., CFTC Interpretative Letter No. 94-12, (Current Transfer Binder), Comm. Fut. L. Rep. (CCH) para. 25,993 (December 27, 1993) (capsule performance disclosure permitted for CPO's other pools; CFTC Interpretative Letter No. 94-10, (Current Transfer Binder) Comm. Fut. L. Rep. (CCH) para. 25,991 (December 16, 1993) (capsule performance disclosure permitted); CFTC Interpretative Letter No. 93-107, (Current Transfer Binder) Comm. Fut. L. Rep. (CCH) para. 25,899 (October 26, 1993) (CPO permitted to omit disclosures concerning its single advisor pools in Disclosure Document for a multi-advisor pool under certain conditions); CFTC Interpretative Letter No. 92-12, (1990-1992 Transfer Binder) Comm. Fut. L. Rep. (CCH) para. 25,343 (July 28, 1992) (CPO permitted to omit required disclosures concerning CTAs and investee pools allocated less than 10% of pool's assets under certain conditions); and CFTC Interpretative Letter No. 92-9, (1990-1992 Transfer Binder) Comm. Fut. L. Rep. (CCH) para. 25,300 (June 1, 1992) (CPO permitted to use two-part Disclosure Document with past performance of CTAs in second part delivered contemporaneously with first part) and Advisory 27-92 (June 3, 1992) (Commission has no objection to use of two-part Disclosure Document subject to conditions set forth in Interpretative Letter 92-9), issued in connection therewith. The foregoing generally are discussed at 59 FR 25351, 25353-54. --------------------------------------------------------------------------- Thus, the proposal to revise the part 4 rules reflected the Commission's experience in addressing a wide range of CPO and CTA disclosure issues under the prior rules, the evolution of the marketplace, the development of new trading structures and the views of the public and of market participants. B. National Futures Association Proposals As detailed in the Proposing Release,\16\ on March 15, 1994, the National Futures Association (``NFA'') submitted to the Commission proposed amendments to, and interpretations of, NFA's Compliance Rules based upon the recommendations of NFA's Special Committee for the Review of CPO/CTA Disclosure Issues (``NFA's Submission''). NFA's Submission consisted of several parts, including: Proposals concerning presentation of past performance data, including proposed capsule formats for CPO and CTA performance; proposed requirements for calculation and disclosure of break-even analyses by CPOs; proposed rules for the use of hypothetical trading results by NFA members in promotional material; and proposals dealing with the use of ``nominal'' or ``notionally funded'' accounts. The proposals requiring, and providing instructions for, break-even analyses were published for public comment and subsequently approved by the Commission on April 26, 1995, substantially as proposed.\17\ Rule 4.10(j) [[Page 38148]] incorporates by reference NFA's instructions for calculating the ``break-even'' point. The portion of NFA's Submission concerning hypothetical trading results \18\ was modified by NFA in response to Commission and public comments and remains under consideration.\19\ Rule 4.41, revised as discussed herein, permits persons to follow either the Commission or rules adopted by NFA. \16\ See 59 FR 25351, 25354. \17\ NFA Compliance Rule 2-13(b) and Interpretive Notice to Compliance Rule 2-13(b). The ``break-even'' analysis is a computation of the trading profit that a pool must realize in the first year of an investor's participation for the investor to recoup his or her initial investment. \18\ Proposed NFA Compliance Rule 2-29(c). \19\ Separately, the Commission contemplates further review of the subject of hypothetical performance presentations to assure adequate safeguards against the misuse of such disclosure. --------------------------------------------------------------------------- NFA's Submission included proposed rules with respect to past performance presentations, which were considered by the Commission in preparing the recommendations set forth in the Proposing Release. As noted in the Proposing Release, the portion of NFA's Submission addressing the use of ``nominal'' or ``notionally funded'' accounts was remitted to the NFA for further explanation and documentation. The Commission is not addressing the issue of ``nominal'' or ``notional'' account size in this release. C. April 25, 1995 Roundtable Discussion On April 25, 1995, the Commission convened a roundtable discussion led by Chairman Mary L. Schapiro, entitled ``Rethinking Past Performance Disclosure,'' to elicit input from industry, academic, end- user, regulatory and other sources with respect to public policy issues relevant to past performance disclosure, as well as technical and pragmatic aspects of past performance presentations. A number of the speakers expressed the view that past performance data alone are not directly predictive of future trading results but that past performance data provide information that is important in evaluating a contemplated pool offering or trading program. For example, patterns of volatility and other trading patterns in various market conditions may be evident. Participants also noted the tendency for past performance data to have a potent persuasive effect, which some viewed as significantly exceeding the usefulness of such information as a basis for an investment decision. Speakers discussed the effect of such factors as the volume of performance data and the format in which performance information is provided, the utility of monthly as opposed to annual rates of return, and the extent to which meaningful benchmarks or standards are available to measure performance.\20\ \20\ A summary of the roundtable discussion is on file with the Commission's Office of the Secretariat. --------------------------------------------------------------------------- D. Review of Public Comments The Commission received thirty comment letters in response to the Proposing Release: three from persons registered as CTAs; five from persons registered as both a CPO and a CTA; two from persons registered as both a CTA and an introducing broker (``IB''); two from persons registered as futures commission merchants (``FCMs''); two from self- regulatory organizations; two from a futures industry trade organization; two from certified public accountants; nine from law firms; two from bar associations; and one from an academician. The commenters strongly supported the rulemaking in general. Many commenters, however, advocated changes in various aspects of the proposed rules. The Commission has carefully considered the comments received and, based upon its review of the comments and its own reconsideration of the proposed amendments, has determined to adopt the revisions contained in the Proposing Release, with certain modifications, as discussed below. Comments received on the proposed amendments are discussed below in the context of the particular provisions to which they relate. The Commission believes that the revised rules, as adopted, not only respond to the concerns of the commenters but, also, meet the regulatory objectives of this rulemaking. Notwithstanding the adoption of the rule amendments discussed herein, the Commission intends that the staff will continue to respond to requests for relief from the Part 4 rules on a case-by-case basis consistent with the objectives and principles of this rulemaking. The Commission also is exploring possible mechanisms for addressing additional CPO and CTA disclosure issues with the benefit of industry and other external input, including input from other federal and state regulators, on an ongoing basis. II. Transitional Provisions The revisions being announced today will become effective thirty days from the date hereof, but Disclosure Documents may be prepared, filed and used in accordance with the revised rules prior to the effective date. To facilitate the transition to compliance with the revised rules adopted herein, the Commission has determined that, for a period of six months after the effective date, it will not take enforcement action against any person solely on the basis of such person's use of a Disclosure Document prepared pursuant to the former rules rather than the revised rules. For pools that are continuously offered, amendment of the Disclosure Document is not required solely due to the rule revisions announced herein, and operators of such pools may make conforming changes as part of their next regular update. Persons to whom the Division previously has granted exemptive or no-action relief permitting them to prepare Disclosure Documents in accordance with certain provisions of the proposed rules set forth in the Proposing Release are reminded that such relief is superseded by the revisions adopted herein, and any Disclosure Document used by any such person subsequent to the effective date of these revisions must comply with the revised rules. III. Summary of Rule Changes The following summary is intended to provide interested persons with information concerning significant changes to the Commission's disclosure framework and the manner in which those changes vary, if at all, from the Commission's proposals. These and all other changes to part 4 and other Commission rules are discussed below in the section- by-section analysis. For purposes of this release, the rules as in effect prior to the amendments discussed herein are referred to as the ``former'' rules. A. Definitions \21\ \21\ The section-by-section analysis of revised and new definitions is set forth in Section IV below. --------------------------------------------------------------------------- Many of the proposed amendments set forth in the Proposing Release introduced new concepts into the rules. As a consequence, the Proposing Release contained several new definitions designed to modernize the rules in light of marketplace developments and to aid in implementation of the revised rules. Several of these new definitions have been adopted with modifications: ``multi-advisor pool'' (Rule 4.10(d)(2)); ``principal-protected pool,'' which was proposed as ``limited risk pool'' (Rule 4.10(d)(3)); ``trading manager'' (Rule 4.10(h)); ``major commodity trading advisor'' (Rule 4.10(i)); ``major investee pool'' (Rule 4.10(d)(5)); ``trading principal'' (Rule 4.10(e)(2)); and ``break-even point'' (Rule 4.10(j)). Two of the proposed definitions have been [[Page 38149]] eliminated,\22\ and three additional definitions which were not included in the Proposing Release have been added: ``investee pool'' (Rule 4.10(d)(4)), ``draw-down'' (Rule 4.10(k)), and ``worst peak-to- valley draw-down'' (Rule 4.10(l)). As adopted, the new definitions are included in Rule 4.10, and where appropriate, related definitions have been made part of the same paragraph.\23\ \22\ The definition of ``adverse performance,'' which was included in proposed Rule 4.25(a)(8), and the definition of ``trading program,'' which was included in proposed Rule 4.34(a)(5), have not been adopted. \23\ Pool-related definitions are now sub-paragraphs of Rule 4.10(d) and the definition of ``trading principal'' has been included as a sub-paragraph of Rule 4.10(e). --------------------------------------------------------------------------- B. Required Performance Disclosures \24\ \24\ The section-by-section analysis of required performance disclosure revisions is set forth in Section V below. --------------------------------------------------------------------------- 1. CPO Disclosure Documents Rule 4.25 of the amended rules creates a simplified structure for the presentation of required past performance by CPOs. In each case, the presentation must cover the five most recent calendar years and year-to-date, or the entire life of the subject pool, account or trading program, whichever is shorter. (Rule 4.25(a)(5)). a. All required past performance presentations for pools are reduced to a summary, capsule format containing specified core information. (Rule 4.25(a)(1)). In a change from the proposal, CPOs may present monthly rates of return required for the offered pool for five calendar years and year-to-date either in tabular form or in a bar graph. (Rules 4.25(a)(1) and (a)(2)). b. For an offered pool which meets the following criteria, the past performance record of only the offered pool itself is required to be presented in the Disclosure Document: (1) The pool has at least a three-year history of trading commodity interests; and (2) during that minimum three-year period at least seventy-five percent of the pool's assets were contributed by persons not affiliated with the CPO, trading manager, CTA or FCM for the pool, or their respective principals. (Rule 4.25(b)). c. For offered pools which do not meet the three-year operating history criteria of Rule 4.25(b), past performance data for the offered pool, for other pools operated by (or accounts traded by) the CPO and trading manager, and for each ``major'' CTA or ``major'' investee pool is required.\25\ If the CPO or trading manager has less than a three- year history in trading pools for which at least seventy-five percent of pool contributions were made by persons not affiliated with the CPO, trading manager, or CTA for the pool or their respective principals, the past performance of the CPO's (and trading manager's) trading principals \26\ is required to be presented unless that performance does not differ materially from the performance of the offered pool and the CPO of the offered pool. (Rule 4.25(c)(2)). \25\ Rules 4.10(i) and 4.10(d)(5) define the terms ``major commodity trading advisor'' and ``major investee pool,'' respectively. \26\ The term ``trading principal'' is defined in Rule 4.10(e)(2). --------------------------------------------------------------------------- d. The requirement in proposed Rule 4.25(c)(3)(iii) to disclose certain information under the designation ``adverse performance'' has not been adopted. However, the terms ``major commodity trading advisor'' and ``major investee pool'' have been redefined to include CTAs and investee pools with ten percent, rather than twenty-five percent, allocations of pool assets and a narrative discussion of the performance history of non-major CTAs and investee pools is required. (Rule 4.25(c)(5)). 2. CTA Disclosure Documents Under proposed Rule 4.34(a)(1), CTAs would have been required to continue to present the performance of the offered trading program in the full multi-column tabular format previously required under Rule 4.31(a)(3). Performance of all other trading programs directed by the CTA would have been presented in the new capsule format used in CPO Disclosure Documents. As adopted, Rule 4.35(a)(1) permits CTAs to use a capsule format (similar to the capsule format adopted for CPOs) for all programs. The offered trading program's capsule must include monthly rates of return and the numbers of profitable and losing accounts in the trading program. The required monthly rates of return may be presented either in tabular form or as a bar graph, as is the case for the offered pool in a CPO Disclosure Document. As with CPO Documents, all required performance is to be presented for the five most recent calendar years and year-to-date or for the life of the trading program, whichever is shorter. (Rule 4.35(a)(5)). C. Required Non-Performance Disclosures \27\ Required non-performance disclosures are revised as follows. \27\ A section-by-section analysis of required non-performance disclosure revisions is set forth in Section VI below. --------------------------------------------------------------------------- 1. Break-Even Point. CPOs are required to disclose the pool's break-even point, indicating the trading profit the pool must realize in order for a participant to recover his entire initial investment if he redeems his interest after one year. (Rules 4.10(j), 4.24(d)(5) and 4.24(i)(6) for CPOs). The break-even point is required to be calculated in accordance with rules promulgated by a registered futures association pursuant to section 17(j) of the Commodity Exchange Act (the ``Act'').\28\ \28\ 7 U.S.C. 1 et seq. (1994). As noted above, NFA rules governing calculations of the break-even point are included in an Interpretive Notice accompanying NFA Compliance Rule 2-13(b), which Rule and Notice the Commission approved on April 26, 1995. --------------------------------------------------------------------------- 2. Material Litigation. Actions adjudicated on the merits in favor of persons whose litigation history is required need not be disclosed. Required disclosures concerning actions against FCMs and IBs are significantly reduced. (Rules 4.24(l) for CPOs and 4.34(k) for CTAs). 3. Principal Risk Factors. CPOs and CTAs must discuss the principal risk factors of the pool or trading program, including but not limited to volatility, leverage, liquidity and counter-party creditworthiness. (Rules 4.24(g) for CPOs and 4.34(g) for CTAs). 4. Business Background. Disclosure of the business backgrounds of principals is limited to principals (including officers and directors) who participate in making trading or operational decisions for the pool or CTA (or who supervise persons so engaged). Disclosure of CTA and investee pool operator business backgrounds in CPO Disclosure Documents is limited to major CTAs and major investee pools. (Rules 4.24(f) for CPOs and 4.34(f) for CTAs). 5. Conflicts of Interest. Rule 4.24(j) calls for a full description of actual and potential conflicts involving the CPO, the trading manager, major CTA or major pool operator and any principal thereof, as well as any person providing services to the pool or soliciting participants for the pool. The rule also calls for the disclosure of any other material conflict of interest involving the pool. Disclosure with respect to payment for order flow, soft dollar arrangements and similar arrangements is specifically called for. Rule 4.34(j) for CTAs also specifically references payment for order flow and soft dollar arrangements. 6. Fees and Expenses. Rule 4.24(i) requires the CPO to describe the expenses incurred in the previous year and to be incurred in the current year and to disclose fees and commissions in connection with pool solicitations. The rule also specifies significant expense categories not previously enumerated in Rule 4.21 and requires an explanation of [[Page 38150]] the calculation of the pool's break-even point. If a fee is determined by reference to a base amount, the manner in which the base amount is calculated must be disclosed.\29\ (Rules 4.10(j), 4.24(d)(5) and 4.24(i) for CPOs, and 4.34(i) for CTAs). \29\ Except for this provision, Rule 4.34(i) for CTAs is unchanged from the former rule. D. Non-Required Disclosures \30\ 1. Proprietary Trading Results. As proposed and as adopted, the rules provide that proprietary trading results presented in either a CPO or CTA Disclosure Document must be labelled as such and placed at the end of the document. (Rules 4.24(v) and 4.25(a)(8) for CPOs, and 4.34(n) and 4.35(a)(7) for CTAs). \30\ A detailed discussion of non-required disclosures is included in Sections V and VI below. --------------------------------------------------------------------------- 2. Supplemental Information. Proposed Rules 4.24(v) and 4.33(n) generally would have required that information not specifically called for by Commission rules or federal or state securities laws or regulations could only appear following the related required disclosure. The new rules, as adopted, require that any supplementally provided performance information be presented after the entire required performance presentation. Supplemental non-performance information relating to required disclosures may be included with the respective related required disclosures. Other supplemental information is required to follow the last required disclosure, and any proprietary, hypothetical, simulated or pro forma \31\ trading results must be placed at the end of the Disclosure Document. Supplemental information must not mislead or obscure or diminish in prominence any required disclosure. (Rules 4.24(v) for CPOs and 4.34(n) for CTAs). \31\ However, pro forma adjustments to performance data are required for certain purposes and such adjustments are not affected by the restrictions upon placement of supplemental information. See Section V.C.3., infra. --------------------------------------------------------------------------- E. Format Improvements to Enhance Readability \32\ A number of revisions to the rules are intended to enhance the accessibility and prominence of relevant disclosures. Disclosure Documents are now required to contain a table of contents. Further, the number and content of various previously required bold-face ``boilerplate'' risk and cautionary statements has been reduced. Certain core information, including the break-even point, is required to be set forth in the forepart of the document. (Rules 4.24(a) through (d) for CPOs and 4.34(a) through (d) for CTAs). \32\ The section-by-section analysis of format improvement revisions is set forth in paragraph B.6. of Section V and in Section VI below. --------------------------------------------------------------------------- A significant change from the Proposing Release is the renumbering of the CTA disclosure rules to correspond to the numbering of the CPO disclosure rules. To accomplish this, proposed Rules 4.32, 4.33, 4.34 and 4.35 have been adopted as Rules 4.33, 4.34, 4.35 and 4.36, respectively, and Rule 4.32 has been reserved. ------------------------------------------------------------------------ CPO CTA Subject rule rule ------------------------------------------------------------------------ Required delivery of Disclosure Document................ 4.21 4.31 Report to pool participants............................. 4.22 ...... Recordkeeping........................................... 4.23 4.33 General disclosures required............................ 4.24 4.34 Performance disclosures................................. 4.25 4.35 Use, amendment and filing of Disclosure Document........ 4.26 4.36 ------------------------------------------------------------------------ F. Other Revisions \33\ The rule amendments also are designed to facilitate pool offerings, particularly with respect to areas of overlap or potential inconsistency with the rules of the Securities and Exchange Commission (``SEC''). Thus, CPOs and CTAs may now update Disclosure Documents every nine months, rather than every six months as formerly required. (Rules 4.26(a) for CPOs and 4.36(a) for CTAs.) In addition, CPOs may provide accredited investors with a notice of intended offering and statement of the terms of the proposed offering, prior to delivery of a Disclosure Document. (Revised Rule 4.21(a) for CPOs.) \33\ The section-by-section analysis of other revisions (including: Deletion of certain requirements to state that a disclosable situation does not exist; changes to the Disclosure Document amendment, filing and use requirements; and technical conforming changes) is set forth in Section VII below. --------------------------------------------------------------------------- G. Distribution Table In light of the extensive substantive and organizational revisions to the content of Disclosure Documents, and therefore to the part 4 rules, the Commission is setting forth below a distribution table to assist interested persons in complying with the new disclosure framework for CPOs and CTAs. Distribution Table ------------------------------------------------------------------------ Old section New section ------------------------------------------------------------------------ 1.55(a)(1)(iii) 4.10(d)............................ 4.10(d)(1) 4.10(d)(2)-(d)(5) 4.10(e)............................ 4.10(e)(1) 4.10(e)(2) 4.10(h)-(1) 4.21(a)............................ 4.21(a) 4.24(c) 4.24(d) 4.21(a)(1)(i)-(1)(vii)............. 4.24(d)(1)-(d)(2), 4.24(e) 4.21(a)(1)(viii)................... 4.24(h) 4.24(d)(3), 4.24(d)(5) 4.21(a)(2)......................... 4.24(f) 4.24(g) 4.21(a)(3)......................... 4.24(j) 4.21(a)(4)......................... 4.24(n), 4.25 4.21(a)(5)......................... 4.24(n), 4.25 4.21(a)(6)......................... 4.24(t) 4.21(a)(7)......................... 4.24(i)(i)-(i)(4) 4.21(a)(8)......................... 4.24(s) 4.21(a)(9)......................... 4.24(h)(4) 4.24(o) 4.21(a)(10)........................ 4.24(p) 4.21(a)(11)........................ 4.24(q) 4.21(a)(12)........................ 4.24(r) 4.24(k) 4.21(a)(13)........................ 4.24(l) 4.21(a)(14)........................ 4.24(i)(5) 4.21(a)(15)........................ 4.24(m) 4.21(a)(16)........................ 4.24(u) 4.24(v) 4.21(a)(17)........................ 4.24(b) 4.21(a)(18)........................ 4.24(a) 4.21(b)............................ 4.26(c) 4.21(c)............................ 4.24(d)(4) 4.21(d)............................ 4.21(b) 4.21(e)............................ 4.26(a) 4.21(f)............................ 4.26(b) 4.21(g)............................ 4.26(d) 4.21(h)............................ 4.24(w) 4.31(a)............................ 4.31(a) 4.34(c) 4.34(d) 4.31(a)(1)(i)...................... 4.34(d)(1) 4.31(a)(1)(ii), 4.31(a)(iv)........ 4.34(e) 4.31(a)(1)(iii).................... 4.34(h) 4.31(a)(2)......................... 4.34(f) 4.34(g) 4.31(a)(3)......................... 4.34(m), 4.35 4.31(a)(4)......................... 4.34(i) 4.31(a)(5)......................... 4.34(j) 4.31(a)(6)......................... 4.34(l) 4.31(a)(7)......................... 4.34(k) 4.34(n) 4.31(a)(8)......................... 4.34(b) 4.31(a)(9)......................... 4.34(a) 4.31(b)............................ 4.36(c) 4.31(c)............................ 4.34(d)(2) 4.31(d)............................ 4.31(b) 4.31(e)............................ 4.36(a) 4.31(f)............................ 4.36(d) 4.31(g)............................ 4.34(o) 4.32............................... 4.33 4.41(b)(1)......................... 4.41(b)(1)(A)-(b)(1)(B) ------------------------------------------------------------------------ IV. Definitions A. Major Commodity Trading Advisor: Rule 4.10(i) In proposed Rule 4.10(k), the term ``major commodity trading advisor'' [[Page 38151]] would have been defined as a CTA allocated or intended to be allocated at least twenty-five percent of the pool's aggregate initial margin and premiums for futures and commodity option contracts. The Commission requested comment concerning this proposed definition, specifically as to the use of a percentage of the pool's aggregate initial margin and premiums for futures and commodity option contracts as compared to a percentage of the pool's total assets, which was proposed in Rule 4.10(l) as the basis for determining whether an investee pool would be a major investee pool. The Commission asked whether the proposed distinction between the definition of major CTA and major investee pool would appropriately reflect the relative risks of direct futures trading as compared to trading through vehicles which limit the risk of loss to the initial investment. The majority of the commenters on the major CTA definition recommended that the definition be based on the percentage of the pool's net asset value allocated to the CTA, rather than on the percentage of the pool's aggregate initial margin and option premiums. Commenters stated that it would be difficult to determine how much of the assets allocated to a CTA would be used for margin and premiums, noted that pool operators do not base allocations to CTAs on margins and premiums, and urged that the amount of assets allocated to a CTA better indicates the CTA's potential impact on the pool's performance. Several commenters suggested substitute benchmarks, including standards based on the CTA's ``trading level,'' i.e., the portion of the pool's ``market exposure'' allocated to the CTA and the portion of the pool's assets committed to trading that had been allocated to the CTA. The Commission was also urged to provide expressly that pool assets allocated to a CTA include notional equity, since otherwise the standard may fail to reflect the actual portion of the pool's assets at risk with the CTA, and to use the percentage of pool assets allocated to an advisor specified in the written agreement between the advisor and the pool operator to measure the allocation amount, regardless of how such allocations are drawn upon by advisors from time to time for margin and premiums. A number of commenters expressed agreement with the proposed twenty-five percent threshold amount (while urging that it be based on pool assets). The Commission agrees with the concept advanced or implicit in several of the comment letters that a key objective of defining major CTAs is to gauge the ability of the various CTAs for the pool to place the assets of the pool at risk. To further this objective, the Commission has adopted a revised definition of major CTA in Rule 4.10(i). Under the revised definition, the determination as to whether a CTA is a major CTA is based upon the percentage allocation to the CTA of the pool's aggregate net assets or the aggregate value of the net assets allocated to the pool's trading advisors, whichever is smaller, as determined by the agreement between the CPO and the CTA. These alternate measures are designed to assure that the major CTA definition identifies CTAs which have the ability to expose the pool's assets to significant risk because the amount of funds over which they have trading authority represents a significant proportion either of the pool's net asset value or of the aggregate value of the assets allocated to the pool's trading advisors, whichever is less.\34\ As discussed more fully below, the Commission has determined to use a lower percentage threshold of ten percent in lieu of the proposed twenty-five percent threshold as part of a restructuring of the CTA and investee pool performance disclosure requirements of Rule 4.25 to eliminate the proposed category of ``adverse performance,'' which would have applied to CTAs with allocations of ten percent to twenty-five percent of the pool's futures margins and commodity option premiums. \34\ Adoption of this standard for determining a major CTA is not intended to address or relate to the use of so-called ``notional'' or ``nominal'' account sizes for purposes of calculation of rates of return. --------------------------------------------------------------------------- Thus, under the alternate test being adopted in Rule 4.10(i), if, for example, the total dollar value allocated to advisors for commodity interest trading represented fifty percent of the net asset value of the pool, a trading advisor allocated ten percent of the total dollar value allocated to advisors, even though that amount would represent less than ten percent of the pool's assets, would be a major CTA.\35\ This result is appropriate because the major CTA definition is designed to include CTAs who hold authority over a substantial portion of the pool's commodity interest trading, even if the absolute dollar value of the funds allocated to the CTA is relatively small compared to the total assets of the pool. Conversely, in the unlikely scenario of a CTA having an allocation that, although insignificant compared to the aggregate allocations to CTAs, is significant relative to the assets of the pool, that CTA should also be considered major. This scenario could occur if CTAs collectively are allocated more than the net asset value of the pool; \36\ in such a case, a CTA might, in effect, be trading more than ten percent of the pool's assets even though his allocation represented less than ten percent of total CTA allocations. In such a case, the CTA should be considered a major CTA, thus potentially resulting in a pool having more than ten major CTAs, based upon the level of exposure of pool assets. \35\ The standards discussed herein do not affect the scope of the existing exemption available under Rule 4.12(b), which provides an exemption from, inter alia, past performance disclosure, for pools that commit no more than ten percent of the fair market value of their assets to establish commodity interest positions and trade such commodity interests in a manner solely incidental to their securities trading. \36\ The Commission does not encourage such allocations and notes that the leverage inherent in such vehicles creates corresponding risks, which must be appropriately disclosed. The Commission notes the recent heightened recognition in the domestic and foreign regulatory communities of the risks inherent in leveraged instruments and trading vehicles. --------------------------------------------------------------------------- Because the major CTA definition is intended to identify advisors whose trading is significant to the pool in terms of overall risk, any percentage allocation figure based upon a single benchmark such as funds allocated by written or other agreement is likely to provide only a rough comparative measure. This is so because trading advisors' programs may lead to different degrees of futures or other risk exposure and different volatility patterns despite the same quantitative allocation of funds. Consequently, in determining whether a trading advisor's performance should be disclosed as material information, even if the trading advisor would not constitute a major CTA under the definition set forth in Rule 4.10(i), the pool operator should assess the likelihood that the CTA's trading, given the leverage used, may expose significantly more of the fund's net asset value in a worst case scenario than his percentage allocation level would indicate. Such a case may warrant inclusion of capsule performance information for the CTA even if his allocation does not exceed the ten percent threshold. In most cases, however, a textual discussion will suffice, and the Commission has emphasized the requirement for this type of supplementary disclosure as to non-major CTAs generally by adopting Rule 4.25(c)(5), discussed infra. Further, a CTA's performance may be marketed in such a manner as to render more comprehensive disclosure of his performance material, e.g., the CTA may be accorded ``major'' importance by [[Page 38152]] virtue of prominent references to such CTA in promotional material. The comments indicated, and the Commission would generally expect, that allocations to CTAs would generally be evidenced by written agreement, between the CPO (or the trading manager, if any) on behalf of the pool and the CTA, assigning a particular dollar amount of the pool's assets to be traded by the CTA. This dollar amount would be converted into a percentage using the alternate standards in Rule 4.10(i). CPOs should be prepared to document their determinations as to the status of CTAs as major or non-major for audit purposes but, in most cases, the written agreement should be sufficient. Proposed Rules 4.10(k) and 4.10(l) would have required that ``major'' CTA and investee pool status be determined at the time the Disclosure Document is prepared \37\ and on an ongoing basis.\38\ As the Commission explained in the Proposing Release, the ``major commodity trading advisor'' and ``major investee pool'' definitions are intended to include CTAs or investee pools to whom the CPO of a pool that has not commenced trading intends to make allocations at or above the specified thresholds.\39\ Similarly, any CTA or investee pool to whom the CPO of an operating pool intends to reallocate assets such that the allocations to such CTA or investee pool will total ten percent or more also would be included. One commenter recommended that the asset allocations which determine major CTA or major investee pool status only be required to be accurate as of a date not more than ninety days prior to the date of the Disclosure Document. In response, the Commission notes that, pursuant to Rule 4.26(c), the CPO must notify existing participants of changes in major CTAs and investee pools, to the extent they represent material changes, within twenty-one days and must so notify previously solicited prospective participants prior to accepting or receiv- ing funds from such prospective participants. This can be accomplished by formally amending the Disclosure Document, ``stickering'' the document, including information in an Account Statement, or other similar means. Whether a given major CTA or investee pool change is material would depend upon a variety of factors such as the overall distribution of pool assets to CTAs and investee pools, the historical frequency of such changes and the pool's overall trading program. Substitutions of, and reallocations to, CTAs or investee pools are more likely to be material changes for a pool with one or two trading advisors, than for a pool that accesses a variety of advisors and investee pools and that redirects its assets frequently in response to changes in market conditions. \37\ The definitions adopted in Rules 4.10(i) and 4.10(d)(5) include CTAs and investee pools ``allocated or intended to be allocated * * *'' \38\ Rule 4.26(c) requires distribution of corrections of any material inaccuracies to all participants within twenty-one days of the date on which the CPO knows or has reason to know of the inaccuracy. \39\ 59 FR 25351, 25357. --------------------------------------------------------------------------- B. Major Investee Pool: Rule 4.10(d)(5) Proposed Rule 4.10(l) would have defined ``major investee pool'' as an investee pool allocated or intended to be allocated at least twenty- five percent of the assets of a pool. As noted above, in contrast to the proposed definition of major CTA, which would have relied upon a percentage of the pool's initial futures margin and commodity option premiums, the major investee pool definition was based upon the percentage of the assets of the investor pool allocated to the investee pool. This distinction in the basis for determining allocations to pools was based upon the fact that investments in other pools generally expose the investor pool only to loss of the initial investment and that the full amount of the investment is required to be paid at the inception of the investment. The relative importance of investee pools to prospective pool participants is thus appropriately determined by reference to the proportion of the pool's total assets actually invested in the investee pool, and the major investee pool definition did not appear to present the same issues concerning quantification of relative risk exposure as the major CTA definition. Commenters who addressed the major investee pool definition pointed out that ``investee pool'' was not defined in the Proposing Release or in existing Commission rules. The Commission is adopting in Rule 4.10(d)(4) a definition of ``investee pool'' as ``any pool in which another pool participates or invests, e.g., as a limited partner thereof.'' The Commission is adopting as Rule 4.10(d)(5) a definition of ``major investee pool'' that differs from the proposal in that it specifies that the allocation threshold is ten percent of the net asset value of the pool, instead of twenty-five percent of the assets of the pool. This modification was made in order to make the allocation measure consistent with the capsule performance format, which calls for net asset value. As in the case of the major CTA definition, the proposed twenty-five percent threshold has been reduced to ten percent in light of the elimination of the proposed ``adverse performance'' disclosure requirement for CTAs and investee pools with allocations ranging from ten to twenty-five percent. One commenter noted that in determining the percentage of a pool's assets allocated to an investee pool, as with CTA allocations, notional equity should be included in order to capture the risk exposure created by the investee pool's trading. This approach was advocated because the percentage of the offered pool's assets used to purchase the participation in an investee pool may not reflect the additional risk created where the assets of the investee pool are traded at a leverage factor that results in trading exposure of, for example, twice the actual assets of the investee pool. Although the Commission does not believe that this consideration warrants express treatment in the major investee pool definition, it recognizes that there may be applications of the major investee pool definition, as in the case of CTA allocations, where the basic benchmarks used in the rule do not capture all of the investee pools that may be of major impact on the offered pool. In such cases, i.e., where the investee pool is traded on a highly leveraged basis, the pool operator should be mindful of the obligation to disclose all material information and should take into consideration the nature of the investee pool's trading in determining whether it should be treated as a major investee pool for disclosure purposes. The time at which major investee pool status is determined is discussed in paragraph A, above. C. Multi-Advisor Pool: Rule 4.10(d)(2) Proposed Rule 4.10(h), the multi-advisor pool definition, would have employed a twenty-five percent or greater allocation standard based on the pool's aggregate initial margin and premiums for futures and commodity option contracts. Thus, as proposed, the ``multi-advisor pool'' definition effectively would not have applied if a pool had one major CTA or major investee pool, and the minimum number of CTAs in a multi-advisor pool would have been five. Two commenters asserted that any pool with two or more CTAs should be considered a multi-advisor pool, although one commenter acknowledged that a pool that allocated ninety percent of its assets to one CTA should not qualify as a multi- advisor pool. As adopted, the definition of ``multi-advisor pool'' in Rule 4.10(d)(2) is a pool in which no CTA is allocated or intended to be allocated more than twenty-five percent of the pool's funds available for commodity interest trading [[Page 38153]] and in which no investee pool is allocated or intended to be allocated more than twenty-five percent of the pool's net assets. (Rule 4.10(d)(2)). In determining whether a CTA has been allocated more than twenty-five percent of the pool's funds available for commodity interest trading, the alternate standard in the major CTA definition should be used, i.e., the percentage allocation is the amount of funds allocated to the trading advisor by agreement with the CPO, expressed as a percentage of the lesser of the aggregate value of the assets allocated to the pool's trading advisors or the net assets of the pool at the time of allocation. D. Principal-Protected Pool: Rule 4.10(d)(3) The term ``limited risk pool'' was defined in proposed Rule 4.10(i) as a pool (commonly referred to as a ``guaranteed pool'') that is designed to limit the loss of the initial investment of its participants. Commenters pointed out that most pools are formed as limited partnerships, thus limiting at least some of the participant's risk. Other commenters offered alternative terms \40\ or suggested that the definition specify that loss would be limited by guaranty, letter of credit or other third-party undertaking. As adopted in Rule 4.10(d)(3), the term has been redesignated ``principal-protected pool,'' but the definition is unchanged from that set forth in the Proposing Release. \40\ Suggested options included ``capital protected pools'' and ``principal return guaranteed pools.'' --------------------------------------------------------------------------- E. Trading Manager: Rule 4.10(h) As proposed in Rule 4.10(j), and as adopted in Rule 4.10(h), the ``trading manager'' of a pool is defined as any person other than the pool's CPO with authority to allocate pool assets to CTAs or investee pools. Rule 4.10(h) further makes clear that sole or partial authority will bring a person within the trading manager definition. No comments addressing the trading manager definition were received. Commission rules have not previously expressly taken account of pool structures in which a trading manager, rather than the pool's CPO, allocates pool assets. The Commission emphasizes that trading managers are CTAs and are required to be registered as such. Thus, although trading managers do not function as direct traders for the pool, they have the ability to influence the pool's trading to a very significant degree. Due to the importance of the role of trading manager, in a number of contexts the proposed rules would have made disclosure of the trading manager's performance a substitute for that of the CPO. However, as noted below, the Commission has revised the proposed rules to require disclosure both as to a pool's CPO and the trading manager, if any, in a number of contexts, e.g., conflicts of interest, on the ground that in the vast majority of cases, even if the CPO has delegated substantial responsibility to the trading manager to hire and monitor CTAs, the CPO retains ultimate responsibility for operation of the pool. However, with respect to past performance disclosure, if the CPO has completely delegated trading authority to a trading manager and the past performance of the trading manager does not differ materially from that of the commodity pool operator, only the trading manager's past performance is required to be disclosed. F. Trading Principal: Rule 4.10(e)(2) A ``trading principal'' would have been defined in proposed Rule 4.10(m) as a principal of a CPO or CTA who participates in making commodity interest trading decisions for a pool or client or who supervises, or has authority to allocate pool assets to, persons so engaged. The sole commenter who addressed this definition urged that it be limited to principals who make trading decisions, excluding principals who supervise or hire traders. The Commission notes, however, that persons who select or supervise traders effectively determine how a pool's or client's assets will be traded. Accordingly, where disclosure of information concerning traders is appropriate, the same information should be required of those who supervise or hire them. As adopted in Rule 4.10(e)(2) only grammatical changes were made to the definition of ``trading principal'' in proposed Rule 4.10(m). G. Break-Even Point: Rule 4.10(j) In order to make the impact of costs and fees on an investment more understandable to the prospective investor, the Commission proposed that the narrative discussion of fees and expenses be supplemented by presentation of the ``break-even point'' for an offered pool and a clear explanation of how that break-even point is calculated. Proposed Rule 4.10(n) would have defined ``break-even point'' as the trading profit that a pool or trading program must realize in its first year to equal all fees and expenses such that a participant or client will recoup its initial investment, as calculated pursuant to rules promulgated by a registered futures association.\41\ \41\ Proposed Rule 4.10(n) would also have required that the break-even point be expressed as a percentage of the minimum unit of initial investment based upon assumed redemption of the initial investment at the end of the first year of investment. --------------------------------------------------------------------------- Many commenters supported the proposal to require disclosure of a pool's break-even point.\42\ However, comments on the break-even point (and the requirement to disclose the relevant calculations) indicated some confusion regarding whether the break-even point is based on the pool's first year of operation or an investor's first year of participation in the pool. For ongoing pool offerings, commenters suggested that the break-even point be optional after the first year of a pool's operation, that it be based on a prior year's actual results, or that a range of break-even points be permitted keyed to various total offering sizes. \42\ Comments addressing the manner of calculating the break- even point are discussed below with Rule 4.24(i) (``Fees and Expenses'') in paragraph B.5. of Section VI. --------------------------------------------------------------------------- As adopted, Rule 4.10(j) defines the term ``break-even point'' as the trading profit that a pool must realize in the first year of a participant's investment to equal all fees and expenses such that the participant will recoup its initial investment. The break-even point is required to be calculated pursuant to rules promulgated by a registered futures association and it must be expressed both as a dollar amount and as a percentage of the minimum unit of initial investment. The proposed definition referred to the trading profit that a pool or trading program must realize in the pool or trading program's first year, and the break-even point was not expressly required to be presented as a dollar amount.\43\ \43\ Rule 4.10(j) omits the reference in the proposed rule to ``trading program'' and ``client.'' A break-even point is not required for CTA Disclosure Documents, as CTA clients generally are subject to a much simpler fee and expense structure than are pool participants. --------------------------------------------------------------------------- The Commission is clarifying that the break-even point must present the trading profit that the pool must realize in the first year of an investor's participation in order for the investor to recoup his initial investment, and Rule 4.10(j) as adopted so states. As noted above, Rule 4.10(j) provides that the break-even point must be calculated pursuant to rules promulgated by a registered futures association. NFA's Interpretive Notice accompanying its Compliance Rule 2-13(b) sets forth the manner in which the break-even point must be calculated and includes a sample break-even presentation. The amount of trading profit required for the [[Page 38154]] net asset value per unit of participation after one year to equal the initial selling price per unit is expressed both as a dollar amount and as a percentage of the initial selling price per unit. The Commission based its approval of NFA's amendment to Compliance Rule 2-13 and accompanying Interpretive Notice on, among other things, the understanding that NFA would amend the Interpretive Notice to clarify that the CPO of a continuously-offered pool must include an updated break-even analysis in the pool's Disclosure Document throughout the pool's existence, such that each new participant would be informed of a break-even point that was accurate as of the date of the Disclosure Document.\44\ Revision of the break-even point is thus required for ongoing pool offerings whenever the actual break-even point becomes materially different from that which appears in the Disclosure Document. \44\ The Commission also reminded NFA that in explaining and enforcing member compliance with NFA break-even analysis requirements the fee and expense categories in the Interpretive Notice to Compliance Rule 2-13(b) should not be considered exhaustive or exclusive, and that NFA should ensure that CPOs do not use that listing to avoid including a cost in the pool's break-even analysis. With respect to interest income, the Commission stated its understanding that NFA would require inclusion in the break-even analysis of a projection of a pool's expected interest income at an assumed interest rate reflecting then current cash market conditions, and it stated that to the extent that a person other than a pool participant receives any portion of the pool's interest income, such payment should be disclosed as a fee or expense in the pool's break-even analysis. H. Draw-Down and Worst Peak-to-Valley Draw-Down: Rules 4.10 (k) and (l) Commenters noted that although the capsule performance presentation format in proposed Rules 4.25 and 4.34 required registrants to disclose the largest monthly draw-down and the worst continuous peak-to-valley draw-down for the pool or account, the term ``draw-down'' was not defined. To address this concern, the Commission is adopting as Rule 4.10(k) a definition of ``draw-down'' as ``losses experienced by a pool or account over a specified period.'' Similarly, the Commission has adopted Rule 4.10(l), which defines the ``worst peak-to-valley draw- down,'' \45\ as the greatest cumulative percentage decline in month-end net asset value due to losses sustained by a pool, account or trading program during a period in which the initial month-end net asset value is not equaled or exceeded by a subsequent month-end net asset value. The worst peak-to-valley draw-down must be expressed as a percentage of the initial month-end net asset value, together with an indication of the months and year(s) of such decline from the initial month-end net asset value to the lowest month-end net asset value of the draw-down. For purposes of Rules 4.25 and 4.35, a peak-to-valley draw-down which began prior to the beginning of the most recent five calendar years is deemed to have occurred during such five-calendar-year period. \45\ As discussed in paragraph B.1. of Section V below, the word ``continuous'' has been omitted from the capsule item ``worst continuous peak-to-valley draw-down'' in proposed Rule 4.25(a)(1)(i)(G) and from the item ``worst ever continuous peak-to- valley draw-down'' in proposed Rule 4.25(a)(1)(ii)(F). --------------------------------------------------------------------------- V. Performance Disclosures: Section-by-Section Analysis \46\ A. Introduction As noted above, the Commission is revising and reorganizing the CPO/CTA disclosure rules with a view towards simplification of presentation. Rules 4.21 and 4.31 continue to require CPOs and CTAs, respectively, to deliver a Disclosure Document.\47\ Rules 4.24 with respect to CPOs, and 4.34 with respect to CTAs, set forth requirements concerning disclosure of all matters other than past performance, and Rules 4.25 for CPOs and 4.35 for CTAs set forth past performance disclosure requirements.\48\ \46\ Tables summarizing past performance disclosure requirements under the revised rules and demonstrating the use of the new capsule format are set forth below at paragraph B.7. of this Section V. \47\ Requirements with respect to the use, amendment and filing of the Disclosure Document are now contained in new Rules 4.26 for CPOs and 4.36 for CTAs, discussed more fully below at Section VII. \48\ Captions have been added to the subparagraphs of Rules 4.25 (a), (b) and (c) and Rules 4.35 (a) and (b) to increase ease of reference. --------------------------------------------------------------------------- As proposed and as adopted, past performance disclosure requirements are being substantially condensed with the objective of eliminating required disclosure of performance that is of secondary relevance to the offered pool or trading program. Thus, the revised rules provide a new ``capsule'' format for performance record presentations that is intended to provide a simple, balanced and succinct overview of performance. Use of the capsule format should substantially reduce the volume of performance data presented without sacrificing material content. With respect to past performance in CPO Disclosure Documents, the revised rules focus primarily upon the historical performance of the offered pool. Where the offered pool has a three-year trading history and meets certain contribution criteria as specified in Rule 4.25(b), its past performance generally is the only required performance presentation. (Rule 4.25(b)). Where the offered pool does not have the requisite operating history, the CPO must present performance data for the offered pool, for the CPO (and trading manager, as applicable), and the pool's major CTAs and investee pools. (Rules 4.25 (c)(2) through (c)(4)). A textual discussion of relevant performance factors for non-major CTAs and investee pools also is required. (Rule 4.25(c)(5)). Some performance data may be presented on a composite basis. (Rule 4.25(a)(3)). All performance data may be presented in a capsule format. With respect to CTA Disclosure Documents, the performance of the offered trading program is the primary focus. (Rules 4.35 (a)(1) and (a)(2)). The performance of accounts traded pursuant to other trading programs of the CTA may be presented in single composite, provided the rates of return are not materially different, material differences among the accounts included in the composite are disclosed, and the composite presentation is not misleading. (Rule 4.35(a)(3)). As the volume of required performance disclosures for both CPOs and CTAs is being considerably reduced, the time period for these disclosures is being increased from three years to five years in order to provide investors with a better chronological perspective of the performance records presented in the Disclo- sure Document. (Rule 4.25(a)(5) for CPOs and Rule 4.35(a)(5) for CTAs). This approach accords with the views of the NFA Special Committee for Review of CPO/ CTA Disclosure Issues.\49\ \49\ NFA's Submission at 7. B. Required Performance Disclosures \50\ \50\ To facilitate understanding of the new performance requirements, paragraph B.7., infra, provides: (1) A table summarizing the past performance requirements of Rules 4.25 and 4.35; and (2) examples of capsule performance presentation under the rules. --------------------------------------------------------------------------- 1. Required Performance Disclosures in CPO Disclosure Documents: Rule 4.25 The new summary format for presentation of past performance history is intended to capture the most significant information concerning a pool's performance in a reader-friendly, largely nontabular form. This format will generally permit multiple track records to be provided on a single page. The new format is set forth in Rule 4.25(a)(1) for pool documents and Rule 4.35(a)(1) for CTA documents.\51\ \51\ As discussed more fully below, the Commission has determined to permit CTA documents to present the past performance of the offered trading program in the new capsule format. [[Page 38155]] --------------------------------------------------------------------------- a. Capsule Performance Presentation: Rule 4.25(a)(1) \52\ \52\ Rule 4.10(k), which defines the term ``draw-down,'' and Rule 4.25(a)(7), relating to substantiating past performance calculations, are also discussed in this section. --------------------------------------------------------------------------- CPOs As proposed in Rule 4.25(a)(1)(i), the capsule for pool performance in CPO Disclosure Documents would have been required to contain the following information: The name of the pool; a statement as to whether the pool is privately offered pursuant to the Securities Act of 1933, as amended (the ``Securities Act''),\53\ a multi-advisor pool or a principal-protected pool; the date when the pool commenced trading; the aggregate gross capital subscriptions to the pool; the pool's current net asset value; the ``largest monthly draw-down''; the ``worst continuous peak-to-valley draw-down''; and annual and year-to-date rates of return, computed on a monthly compounded basis,\54\ for the preceding five calendar years and year-to-date (or for the life of the pool if shorter). In the case of the offered pool's capsule, monthly rates of return would have been required for the entire performance period. \53\ For this purpose private offerings may be pursuant to section 4(2) of the Securities Act of 1933, as amended, 15 U.S.C. 77d(2), or Regulation D thereunder, 17 CFR 230.501-230.508 (1994). \54\ See Rule 4.25(a)(1)(i)(H). Annual rates of return computed on a monthly compounded basis assume reinvestment of accrued profits and therefore the investment base on which rates of return are calculated is effectively adjusted by these amounts. --------------------------------------------------------------------------- Similar data would have been required in capsule presentations of the performance of accounts in CPO Disclosure Documents. Proposed Rule 4.25(a)(1)(ii) would have called for inclusion in the capsule format of: The name of the CTA or other person trading the account and the name of the trading program; the date when the CTA began trading client funds and the date of inception of trading for the trading program being disclosed; the number of accounts in the program as of the Disclosure Document date; the total assets under the management of the CTA and in the trading program; the ``largest monthly draw-down'' for the program; the ``worst ever continuous peak-to-valley draw-down'' for the trading program; and annual and year-to-date rates of return for the offered trading program (again, computed on a monthly compounded basis). CTAs As proposed, Rule 4.34(a)(2) would have required all performance presented in CTA Disclosure Documents, with the exception of the performance of the offered trading program, to follow the capsule format as specified in Rule 4.25(a)(1)(ii) (C) through (G). Comments. Commenters expressed uniformly strong support for the proposed new capsule format for past performance disclosure. One commenter, however, recommended that the revised rules expressly permit a CPO to continue to present performance in the multi-column tabular format required by former Rule 4.21(a)(4). Many commenters requested that the Commission define the term ``draw-down,'' as used in the proposed capsule format. Commenters also noted that use of the word ``continuous'' in the capsule item ``worst continuous peak-to-valley draw-down'' could be read to mean that any intermediate upward movement terminates the draw-down, thus permitting a small ``uptick'' to disguise the true magnitude of a long draw-down, since the uptick would break the continuity but not the decline in asset value. Suggested alternatives were ``worst absolute peak-to-valley draw-down'' and ``worst peak-to-valley period.'' One commenter sought confirmation that the proposed rule would require disclosure of the number of successive months during which net asset value failed to exceed the pool's prior high water mark and the total percentage decline over that period. Numerous commenters criticized the proposed requirement that monthly rates of return be presented for the offered pool over the entire five-year performance period (or for the life of the offered pool if less than five years), claiming that such data would detract from the simplicity and clarity of the capsule format. One commenter contended that monthly rates of return are not relevant to a medium to long-term investment such as managed futures. Various alternative indicators of volatility were proposed in lieu of monthly rates of return, including the pool's standard deviation over its life, the best and worst monthly and annual returns, and the number of profitable and losing months. One commenter recommended that the capsule also include such information as largest monthly increase and greatest valley-to- peak increase in order to provide a balanced presentation. A number of commenters urged the Commission to resolve the issue of the use of notional funds and nominal account sizes in performance presentations.\55\ \55\ As noted above, the Commission is reviewing the subject of ``notional funds'' performance data with the benefit of industry, end-user, regulatory and academic input provided at the Commission's April 25, 1995, roundtable discussion and other available data. --------------------------------------------------------------------------- The Commission requested comment as to whether past performance presentations would provide more meaningful information if they were required to include rates of return on a risk-adjusted basis, that is, reduced by the relevant Treasury Bill rate or comparable interest figure, or to break out trading results from passive interest income. The only commenter specifically addressing this request expressed the view that risk-adjusted rates of return would not make performance presentations more meaningful and contended that indexing performance based upon another form of investment implied that participation in a commodity pool was somehow comparable to such other investment. Technical Changes to Capsule The Commission is adopting the capsule format for performance presentations in pool Disclosure Documents, with certain technical modifications as noted below. In adopting the capsule performance format, the Commission stresses that this summary format is designed for purposes of presentation in Disclosure Documents only. CPOs and CTAs must continue to compute performance on the same basis as under the former rules \56\ and to maintain records substantiating such computations in accordance with Rule 1.31.\57\ The Commission is not adopting at this time a requirement that registrants present past performance on a risk-adjusted basis. \56\ Although only the amounts specified in Rules 4.25(a) (1) and (2), and Rules 4.35(a) (1) and (2) need be set forth in the Disclosure Document, the same performance calculations as previsouly required must be made, as specified in Rule 4.25(a)(7) for CPOs and Rule 4.35(a)(6) for CTAs, as such rules may be interpreted by the Commission. The corresponding former rules are former Rule 4.21(a)(4)(ii) and former Rule 4.31(a)(3)(ii), respectively. \57\ Among other things, Rule 1.31 requires all books and records to be maintained for a period of five years and to be available for inspection by any representatives of the Commission or the U.S. Department of Justice. CTAs also are subject to those requirements. --------------------------------------------------------------------------- Draw-Down Information The required draw-down information, which is based upon activity occurring for the most recent five calendar years and year-to-date, is intended to inform prospective participants of the nature of the volatility actually experienced by the pool by demonstrating the significant one-month and sustained declines to which the commodity pool [[Page 38156]] has actually been subject. To ensure that the worst long-term draw-down is properly represented, Rules 4.25(a) and 4.35(a), as adopted, require the capsule to include the ``worst peak-to-valley draw-down,'' eliminating the qualification ``continuous.'' \58\ \58\ The word ``continuous'' is eliminated from Rules 4.25(a)(1) (i)(G) and (ii)(F), and the extraneous word ``ever'' is eliminated from Rule 4.25(a)(1)(ii)(F). --------------------------------------------------------------------------- The Commission also is adopting definitions of the terms ``draw- down'' and ``worst peak-to-valley draw-down.'' Rule 4.10(k) provides that ``draw-down'' means losses experienced by a pool or account over a specified time period. Thus, a draw-down is a decline in net asset value due to reasons other than redemptions or withdrawals. To assist readers who may not be familiar with industry terminology, the Commission has also added a requirement that the capsule format include, in a footnote or otherwise, a definition of the term ``draw- down'' that is consistent with the definition set forth in Rule 4.10(k). Rule 4.10(l) defines ``worst peak-to-valley draw-down'' as the greatest cumulative percentage decline in month-end net asset value due to losses sustained by a pool, account or trading program during any period in which the initial month-end net asset value is not equaled or exceeded by a subsequent month-end net asset value. The rule specifies that the worst peak-to-valley draw-down must be expressed as a percentage of the initial month-end net asset value, together with an indication of the months and year(s) of such decline from the initial month-end net asset value to the lowest month-end net asset value of such decline. For purposes of the revised rules, a peak-to-valley draw- down which began prior to the beginning of the most recent five calendar years is deemed to have occurred during such five-calendar- year period. Both monthly and peak-to-valley draw-down amounts are to be expressed as a percentage of the net asset value at the beginning of the specified period. The largest monthly draw-down indicates the largest net asset loss experienced by the pool in any calendar month, and the month and year in which that loss occurred. The worst peak-to- valley draw-down indicates the largest calendar month-to-calendar month net asset loss experienced by the pool during any period and the months and year in which it occurred. Dating the monthly and peak-to-valley draw-downs permits participants to assess whether the losses were connected to market conditions by comparing the draw-downs of several pools. As explained in the Proposing Release,\59\ a peak-to-valley draw-down of 4 to 8-91/25% would indicate that the peak-to-valley lasted from April to August of 1991 and resulted in a twenty-five percent draw-down of the pool's net asset value. \59\ 59 FR 25351, 25356. --------------------------------------------------------------------------- Monthly Rates of Return The Commission has determined to modify the proposal with respect to monthly rates of return for the offered pool to permit flexibility as to the form of presentation. As adopted, Rule 4.25(a)(2) provides that the capsule for the offered pool must contain monthly rates of return for the five most recent calendar years and year-to-date (or the pool's life, if shorter) presented either in tabular form or in a bar graph. If a bar chart is used, the bar chart must clearly indicate monthly rates of return and must also prominently indicate annual rates of return. Rule 4.25(a)(2)(iv) requires that the CPO make available upon request to prospective and existing participants the supporting data necessary to calculate monthly rates of return for the offered pool as specified in Rule 4.25(a)(1). The Commission notes that registrants may present performance information in the multi-column format specified by former Rule 4.21(a)(4) in addition to the capsule format specified by Rule 4.25(a)(1), provided that any performance presented in the superseded format is treated as supplemental information and is placed following all of the required performance disclosures in the Disclosure Document.\60\ \60\ This statement also applies to CTAs. See Rule 4.24(v) for CPOs and Rule 4.34(n) for CTAs, concerning supplemental disclosures, discussed in paragraph C.1. of this Section V. Registrants who offer notional programs may disclose monthly rates of return in the capsule disclosure for CTA programs using the fully- funded subset described in Advisory 93-13.\61\ Commission staff will provide guidance concerning supplemental data to accompany the capsule disclosure to reflect the range of levels of partial funding and the generic disclosures discussed in Advisory 93-13. \61\ CFTC Advisory 93-13, (Current Transfer Binder) Comm. Fut. L. Rep. (CCH) para. 25,554 (February 12, 1993). Advisory 93-13 requires that CTAs who manage or offer to manage partially-funded (``notionally'' funded) accounts present both actual and nominal funds under management and give certain disclosures in connection with partially-funded accounts. The Advisory also provides a method for presenting rates of return for a trading program in a single table on the basis of a ``fully funded subset'' of accounts within that trading program. --------------------------------------------------------------------------- b. Pools With Three or More Years Operating History That Meet Contribution Criteria: Rule 4.25(b) \62\ \62\ Former Rule 4.21(a)(4) required disclosure of the performance record of the offered pool. If the offered pool had less than a twelve-month performance history, the performance of the CPO and of each of its principals was also required to be disclosed. Former Rule 4.21(a)(5) also required disclosure of the past performance of all other accounts directed by the pool's CTA and each of its principals, regardless of the duration of the pool's operating history. --------------------------------------------------------------------------- As proposed, Rule 4.25(b) would have limited required performance disclosures in pool Disclosure Documents to the offered pool's performance if: (1) The pool had traded commodity interests for three years or more, (2) no fewer than fifteen pool participants were unaffiliated with the CPO, and (3) no more than ten percent of the pool's assets were contributed by the CPO. As stated in the Proposing Release, the Commission believes that, generally, ``where a pool has an extensive operational history, presentation of the pool's own past performance record should fulfill the objectives of past performance disclosure.'' \63\ If, however, the pool's past performance record was accrued under conditions that differed materially from those which will obtain prospectively, the pool's historical performance record alone may not be sufficient. For example, if the pool's past performance record encompasses periods when the pool was essentially a proprietary trading vehicle investing a relatively small amount of funds contributed by third party sources, the performance record generated may have little or no relevance to a publicly offered pool.\64\ Accordingly, to assure that the three-year performance history would not represent the performance of a significantly dissimilar trading vehicle, the Commission proposed to limit past performance disclosure to the past performance of only the offered pool where, and only where, the pool [[Page 38157]] had a three-year trading history with at least fifteen unaffiliated participants and no more than ten percent participation by the CPO. \63\ 59 FR 25351, 25356. \64\ See Elton, Gruber and Rentzler, New Public Offerings. Information and Investor Rationality: The Case of Publicly Offered Funds, 62 J. Bus. 1 (1988); and Edwards and Ma, Commodity Pool Performance: Is the Information Contained in Pool Prospectuses Useful?, Working Paper Series No. 16, Center for the Study of Futures Markets, Col. Bus. Sch. (January 1988). See also, Statement of the Commodity Futures Trading Commission Regarding Disclosure by Commodity Pool Operators of Past Performance Records and Pool Expenses and Request for Comments, 54 FR 5597, (February 6, 1989); and companion release of the Securities and Exchange Commission, Statement of the Commission Regarding Disclosure by Issuers of Interest in Publicly Offered Commodity Pools, 54 FR 5600 (February 6, 1989). --------------------------------------------------------------------------- The Commission requested comment as to whether, where the offered pool has a three-year operating history, that performance record is generally sufficient without supplementary performance data concerning the pool's CTAs or other pools operated by the CPO. Three of the nine commenters who responded to the Commission's request agreed with the proposal, stating that if a pool has a three-year history, only its own past performance should be required. Six of the nine recommended that the twelve-month standard of former Rule 4.21(a)(4), which related to the presentation of other pools operated by the CPO, should be used to identify pools for which only the performance of the offered pool is required. The Commission also sought comment as to whether the offered pool's operating history should be considered for purposes of the three-year minimum if such history was acquired when the pool differed in some material respect from the pool as offered, for example, in cases in which the pool's CTA, types of interests traded or the trading program had been significantly modified or the pool was initially privately offered but subsequently was offered to the public. All but one of the persons who responded to this request stated that material differences should be disclosed but should not disqualify a pool from meeting the three-year criteria of the rule. Several commenters suggested elimination or modification of the requirement that the requisite three-year operating history be obtained when the pool had at least fifteen unaffiliated participants. Commenters warned that pools with high minimum investments (and few participants) would be unjustly penalized by this restriction. Several commenters recommended that the requirement that the CPO have contributed no more than ten percent of the pool's assets be modified to increase the permissible level of CPO participation, e.g., to fifty percent, and two commenters noted that this would harmonize with the fifty percent standard in proposed Rule 4.25(a)(9) for determining whether past performance results must be treated as proprietary trading results for the purpose of separating such results from other past performance information.\65\ Several commenters contended that Rule 4.25 as proposed would have the undesirable effect of discouraging CPOs from investing in the pools they operate. Three commenters proposed adopting either the CPO investment test or the unaffiliated participant test. \65\ Proposed Rule 4.25(a)(9), adopted as Rule 4.25(a)(8), is discussed at paragraph C.2. of this Section V. --------------------------------------------------------------------------- The Commission has adopted Rule 4.25(b) with several modifications to afford greater flexibility in its application. The requirement that the pool have had no fewer than fifteen participants unaffiliated with the pool operator has been eliminated and the maximum level of contribution of assets by the CPO has been increased. As adopted, Rule 4.25(b) provides for past performance disclosure to be limited to that of the offered pool if both of the following criteria are met: (1) The pool has traded commodity interests for at least three years; and (2) during the three-year (or greater) period, at least seventy-five percent of the pool's assets were contributed by persons unaffiliated with the CPO, the trading manager (if applicable), the pool's CTAs, or any of their principals. The performance of an offered pool which has the requisite three- year operating history is required to be disclosed for five full calendar years and year-to-date or, if the pool has less than a five- year history, for the pool's entire operating history,\66\ in the specified capsule format.\67\ The CPO is free to include additional performance information, subject to the provisions relating to supplemental disclosures.\68\ \66\ Rule 4.25(a)(5). \67\ Rule 4.25(b). As adopted, the text of Rules 4.25(b) and 4.25(c) is being amended to clarify that where the offered pool meets the criteria of Rule 4.25(b), the CPO is required to present only the offered pool's performance. Where the offered pool does not meet the Rule 4.25(b) criteria, the CPO must provide additional performance disclosure as detailed in Rule 4.25(c). \68\ See Rule 4.24(v). --------------------------------------------------------------------------- The Commission notes that the twelve-month standard in former Rule 4.21(a)(4) related only to disclosure of the performance of other pools operated by the CPO and did not affect former Rule 4.21(a)(5)'s requirement to disclose the performance of the CTAs for the pool. Under Rule 4.25(b), if the offered pool has the requisite three-year operating history, neither the performance of the CPO's other pools nor the performance of the pool's CTA(s) must be presented. In view of the elimination of all other performance data, including CTA performance under the new disclosure framework, the Commission believes that a three-year rather than a one-year history is the appropriate minimum. The Commission agrees that material differences in the operation or structure of the pool during the three years, given appropriate disclosure, generally should not disqualify the pool from satisfying the three-year criteria. However, registrants should exercise caution in cases in which such differences exist, taking into account that the requirement to disclose all material information includes past performance disclosure and thus that where significant changes in the offered pool might cause presentation of the offered pool's past performance by itself to be misleading, additional performance disclosure may be required. The Commission believes that the different purposes of Rule 4.25(a)(8), which defines proprietary trading results and requires appropriate placement and labelling of such results, and of Rule 4.25(b), which identifies pools for which no performance history other than that of the offered pool is required, warrant different standards as to the relevant amount of proprietary participation. A more stringent limitation upon qualifying pools is appropriate for use in Rule 4.25(b), which eliminates the necessity for certain otherwise required disclosures, as compared to that of proposed Rule 4.25(a)(8). Unlike Rule 4.25(b), which identifies pools for which no additional performance data other than that of the offered pool is required, Rule 4.25(a)(8) determines the percentage at which proprietary participation essentially renders a trading vehicle a proprietary vehicle, the trading results for which were obtained under conditions that render the performance data presumptively inappropriate for inclusion with and, indeed, potentially misleading if included with, the performance of the offered pool. c. Pools With Less Than A Three-Year Operating History: Rule 4.25(c) \69\ Disclosure Documents for offered pools that do not satisfy the criteria of proposed Rule 4.25(b) would have been required under proposed Rule 4.25(c) to include the performance records of the offered pool, each other pool operated or account traded by the CPO (or trading manager), the CPO's (or trading manager's) trading principals if the CPO (or trading manager) had less than a three-year history, and the performance of each ``major'' CTA and ``major'' [[Page 38158]] investee pool.\70\ Disclosure of ``adverse performance'' results would have been required to be indicated (or in the alternative, capsule performance could have been presented) for non-major CTAs allocated at least ten percent of the pool's initial margins and commodity option premiums and for investee pools allocated at least ten percent of the pool's assets.\71\ \69\ Rule 4.25(c) employs certain key terms, ``trading manager,'' ``major commodity trading advisor,'' ``major investee pool,'' and ``trading principal,'' which are defined in Rules 4.10(h), 4.10(i), 4.10(d)(5) and 4.10(e)(2), respectively. These definitions are discussions in detail in Section IV, supra. \70\ If the pool or such persons did not have a prior trading history, indication of the lack thereof would have been required, using legends set forth in Rule 4.25(c). \71\ Proposed Rule 4.25(c)(3)(iii) would also have required that adverse performance be indicated for any account directed, or pool operated, by the CPO, and any trading principal of the CPO or trading manager (if any), unless such person's performance was otherwise required to be disclosed. --------------------------------------------------------------------------- Adverse performance was defined in proposed Rule 4.25(a)(8) as ``any annual return of one hundred basis points less than the ninety day Treasury Bill rate on December 31 of the calendar year in which the performance occurred or any termination of a pool pursuant to a loss termination provision.'' The Commission received comments on various components of Rule 4.25(c). A number of commenters urged the Commission to eliminate the proposed intermediate category for CTAs and investee pools \72\ for whom adverse performance disclosure would have been required and to adopt a two-tier system in which full performance disclosure would be made for CTAs (and investee pools) above the threshold, and none for CTAs (and investee pools) below the threshold. Several commenters suggested that where a CPO makes (and is authorized to make) frequent changes in the pool's CTAs and the size of the allocations to those CTAs, required disclosures with respect to CTAs should be eliminated or substantially reduced. The emphasis in such cases, according to these commenters, should be on the CPO/trading manager's performance operating multi-advisor pools. The Commission notes, however, that the distinction between ``active allocation'' CPOs (or trading managers) and other CPOs (or trading managers) does not appear to be susceptible to a bright line test, as most if not all CPOs and trading managers assume some responsibility for ongoing management and evaluation of CTAs. Consequently, the relative significance of the CPO's or trading manager's asset allocation expertise, as compared to the CTAs' trading program and skills, varies significantly and may not provide an objective basis for distinguishing among pools for past performance disclosure purposes. Accordingly, given the lack of precise standards on which to base a regulatory distinction between dynamically managed multi-advisor pools and other types of pools, the Commission has elected not to employ such a distinction in constructing the past performance disclosure requirements. \72\ The middle tier of the proposed three-tier disclosure scheme consisted of CTAs allocated at least ten, but less than twenty-five, percent of initial futures margin and option premiums, and investee pools allocated at least ten, but less than twenty- five, percent of pool assets. As adopted, Rule 4.25(c) reflects several modifications from the proposed rules, principally the elimination of the category of CTAs and investee funds for which disclosure of adverse performance would have been required. Upon consideration of the comments received, the Commission has determined to simplify the disclosure requirements such that all CTAs and investee funds will be either major and capsule format presentations of their past performance required (Rule 4.25 (c)(3) and (c)(4)), or non-major and a narrative discussion of matters relevant to their past performance required. (Rule 4.25(c)(5)). As noted above, the definitions of ``major commodity trading advisor'' (Rule 4.10(i)) and ``major investee pool'' (Rule 4.10(d)(5)) have been revised accordingly, such that a ten percent, rather than a twenty-five percent allocation is the operative threshold. With respect to pools that do not have the requisite three-year operating history with at least seventy-five percent of the pool's assets contributed by persons unaffiliated with the CPO, trading manager, CTAs, or their respective principals, Rule 4.25(c) requires presentation of the past performance records of the offered pool, each other pool operated or account traded by the CPO (and trading manager, if applicable), the CPO's (and trading manager's) trading principals if the CPO (or trading manager) has less than a three-year history, and the performance of each major CTA and major investee pool.\73\ If a CTA or investee pool is not ``major,'' a summary description of the performance history of such advisor or pool is required in lieu of capsule performance data. To the extent that performance of principals is required, the revised rules require disclosure of the past performance of ``trading principals'' only.\74\ \73\ If the pool or such specified persons do not have a prior trading history, the lack thereof must be indicated by legends set forth in Rule 4.25(c), and discussed below in paragraph B.6. of this Section V. \74\ See Rule 4.25(c)(2), and Rule 4.10(e)(2) which defines the term ``trading principal,'' discussed above in Section IV. Former disclosure requirements mandated disclosures concerning all principals. --------------------------------------------------------------------------- (i) Performance of Major Commodity Trading Advisors: Rule 4.25(c)(3) For pools that do not have the three-year operating history specified in Rule 4.25(b), the revised rules require capsule format disclosure of CTA past performance only for ``major'' CTAs. As discussed above,\75\ the term ``major commodity trading advisor'' is defined in Rule 4.10(i) as a CTA allocated or intended to be allocated ten percent or more of the smaller of (i) the pool's aggregate net assets, or (ii) the aggregate value of the assets allocated to the pool's trading advisors, as determined based upon the agreement between the CPO and the CTA. \75\ See paragraph A. of Section IV. --------------------------------------------------------------------------- (ii) Performance of Major Investee Pools: Rule 4.25(c)(4) The revised rules also require disclosure of past performance of investee pools constituting ``major investee pools,'' if the offered pool does not meet the standard of Rule 4.25(b). As discussed above,\76\ Rule 4.10(d)(5) defines ``major investee pool'' as an investee pool allocated or intended to be allocated at least ten percent of the net asset value of a pool.\77\ A commenter noted that the term ``investee pool'' was not defined in the former rules or in the proposed revisions. As noted above,\78\ the Commission has adopted a definition of ``investee pool,'' set forth in Rule 4.10(d)(4), as ``any pool in which another pool or account participates or invests, e.g., as a limited partner thereof.'' \76\ See paragraph B. of Section IV. \77\ The term ``pool'' continues to be defined in Rule 4.10(d)(1) as ``any investment trust, syndicate or similar form of enterprise operated for the purpose of trading commodity interests.'' \78\ See paragraph B. of Section IV. --------------------------------------------------------------------------- (iii) CTAs and Investee Pools That Are Not ``Major'': Proposed Rules 4.25(a)(8) and 4.25(c)(3)(iii) The Commission had proposed in Rule 4.25(c)(3)(iii) to require that the CPO of an offered pool that does not satisfy the criteria of Rule 4.25(b) indicate any ``adverse performance'' (or, alternatively, provide a complete past performance capsule) with respect to those CTAs and investee pools allocated at least ten but less than twenty-five percent of the pool's assets (initial margins and premiums in the case of CTAs). Under proposed Rule 4.25(a)(8), ``adverse performance'' would have included: (i) Any annual rate of return that was at least one hundred basis points less than the ninety-day Treasury Bill rate on December 31 of the same [[Page 38159]] year; or (ii) the termination of a pool pursuant to a loss termination provision. Adverse performance would have been indicated by giving the year of occurrence, the rate of return, the identity of the CPO or CTA responsible, and that person's relationship to the offered pool.\79\ The Commission sought comment with respect to the proposed definition of adverse performance, and in particular, as to whether any additional benchmarks would be appropriate for identifying what past performance was sufficiently ``adverse'' to warrant disclosure. \79\ Unless their past performance was otherwise disclosed, Rule 4.25(c)(3)(iii) would also have required an indication of adverse performance with respect to accounts (including pools) traded by the CPO, the trading principals of the CPO (or trading manager), trading principals of major CTAs that had no prior trading history, and the trading principals of major investee pools that had no prior trading history. --------------------------------------------------------------------------- Numerous commenters strongly criticized both the adverse performance characterization and the concept of requiring specific disclosure of performance below a selected risk-free rate. In particular, several commenters objected to the adjective ``adverse'' as unnecessarily pejorative. Several commenters criticized the Treasury Bill benchmark as an inappropriate standard for a managed futures investment, and some commenters proposed alternative triggering events, such as a losing year, or a specified monthly or quarterly draw-down. Commenters asserted that CPOs would generally opt for including the full performance capsule rather than highlight negative results and, thus, that performance presentations would not in fact be streamlined by use of the adverse performance concept. Several commenters suggested a simplified, two-tier allocation standard for CTA and investee pool performance disclosure, with full disclosure for those above a specified percentage (between ten and twenty-five percent) and no performance disclosure for those with lesser allocations. The Commission agrees with the proposition that material CTA or investee pool performance should be fully disclosed, and it believes that multiple standards can be confusing. Accordingly, the Commission is adopting a two-tier disclosure standard for an offered pool's CTAs and investee pools, rather than the three-level approach set forth in the Proposing Release. Under the adopted standard, full performance disclosure, i.e., capsule performance data, is required with respect to CTAs and investee pools with allocations in excess of the designated benchmark, i.e., ``major'' CTAs and investee pools. As adopted, the revised rules omit the proposed requirement to indicate adverse performance for CTAs and investee pools with allocations of at least ten percent, but less than twenty five percent.\80\ Because this type of individual performance disclosure is being eliminated for non-major CTAs and investee pools, the Commission has determined to reduce the percentage allocation standard for major CTAs and investee pools from twenty-five to ten percent. As discussed more fully below, a narrative summary description is required for CTAs and investee pools with lesser allocations. \80\ The requirement in proposed Rule 4.25(c)(3)(iii) to indicate adverse performance on the part of accounts (including pools) directed or operated by the offered pool's CPO, any trading principal of the CPO or any trading principal of the trading manager is also being eliminated. --------------------------------------------------------------------------- (iv) Past Performance of CTAs and Investee Pools That Are Not Major: Rule 4.25(c)(5) As noted above, the Commission has adopted a simplified approach to the disclosure of past performance under which capsule performance data would be required for CTAs and investee pools with ten percent or greater allocations and no intermediate category of CTAs and investee funds would exist for which ``adverse performance'' would be disclosable. The Commission recognizes, however, that any simple quantitative standard such as the ten percent allocation standard can provide only a convenient point of reference to assure a minimum level of performance disclosure, but that pools may be structured, or their assets traded in such a manner, that use of the ten percent allocation standard will not be sufficient to identify all potentially relevant past performance data. Consequently, to supplement the required performance data for major CTAs and investee pools, the Commission is requiring in Rule 4.25(c)(5) a summary description of the performance history of non-major CTAs and investee pools, including monthly return parameters, i.e., highest and lowest monthly rates of return, historical volatility information, an explanation of the degree of leverage used in the trading of such CTA or investee pool, and an identification of any material differences between the performance of such advisors and pools and that of the offered pool's major trading advisors and investee pools. This requirement for summary performance disclosure of non-major CTAs and investee pools reflects the fact that the trading of pool assets may be distributed among multiple CTAs and investee funds, such that a substantial portion of the pool's assets, all of the pool's assets, or even a multiple of the pool's assets, may effectively be allocated to CTAs or investee pools which are not ``major'' and about whom performance data and other information may not generally be presented. Nonetheless, such advisors and investee pools collectively may determine the success or failure of the pool. It also reflects the fact that quantitative allocation figures alone may not be adequate to identify the extent of a particular advisor's or investee pool's impact upon the offered pool. For example, a CTA with a five percent allocation may have such an aggressive trading strategy that the impact of its trading results on the overall return of the pool may be greater than the impact of a trading advisor with an equivalent or larger allocation who follows a less aggressive trading strategy. Under Rule 4.25(c)(5), CPOs will be able to devise individualized approaches to conveying the historical volatility and other pertinent characteristics of the past performance of non-major CTAs and investee pools. (v) Updating Past Performance Information for Certain Persons: Proposed Rules 4.22(a)(4) and 4.26(c) for CPOs \81\ \81\ Because of the differences between CPOs and CTAs, CTAs have no corresponding requirements. --------------------------------------------------------------------------- The Commission proposed to add a new paragraph (a)(4) to Rule 4.22, which would have required the periodic Account Statement that a CPO must deliver to pool participants to include the names of all of the pool's CTAs and investee funds (including investee pools), together with the percentage of pool assets each is allocated, regardless of the amount of pool assets so allocated.\82\ Rule 4.22(a)(4) would also have required that the Account Statement include past performance disclosure with respect to each new major CTA or major investee pool for whom past performance data was not previously provided in the Disclosure Document, i.e., CTAs and investee funds previously allocated less than ten percent of the pool's futures margins or assets, respectively. \82\ Rule 4.22(b) states that the Account Statement must be distributed at least monthly in the case of pools with net assets of more than $500,000 at the beginning of the pool's fiscal year, and otherwise at least quarterly. --------------------------------------------------------------------------- Commenters criticized the proposed inclusion of performance information in Account Statements as unreasonably expensive and burdensome. Some commenters contended that Account Statements are essentially financial statements subject to audit and should [[Page 38160]] not include performance information. Still others argued that Account Statements should not be used to update or amend Disclosure Documents. Other commenters criticized the requirement to identify all CTAs and investee pools, while under proposed Rules 4.24 (e)(3) and (e)(4) only those allocated ten percent or more of pool assets would be required to be identified in the Disclosure Document. The Commission notes that the proposed expansion of the data to be included in Account Statements was designed largely in response to concerns expressed by CPOs as to how to efficiently update Disclosure Documents to include new CTAs and in response to claims that disclosure of the names of investee funds was less onerous and more appropriate in communications with existing pool participants than in Disclosure Documents. Further, such CTA and investee pool information would not be required to be certified by the pool's accountants. Thus, as proposed, the rule would have provided a convenient mechanism for providing a complete, current picture of the pool's CTAs and investee pools. Nonetheless, since the commenters appeared to find the proposed modifications of Rule 4.22 burdensome rather than helpful, the Commission has determined not to amend Rule 4.22. Instead, the existing updating requirements for Disclosure Documents will continue to apply, except as noted below with respect to the periodic update requirement. When a pool acquires a new major CTA or major investee pool, if such event is of material significance, the CPO will be required to notify pool participants and to provide the relevant information including performance records, as required by Rule 4.26(c),\83\ within twenty-one calendar days after the CPO knows or should know of this occurrence. As was the case under the former rules, correction of Disclosure Documents may be accomplished by way of an amended Disclosure Document, Account Statement, a sticker on the Disclosure Document, or other similar means. \83\ Rule 4.26(c), discussed below at paragraph B of Section VII, sets forth the requirements for amending pool Disclosure Documents to reflect a material change in the document. This requirement previously was found in former Rule 4.21(b). --------------------------------------------------------------------------- (vi) Trading Managers: Rule 4.25(c)(2) The revised rules take into account arrangements in which a CPO delegates authority to a trading manager to select CTAs or investee pools to which the pool's assets will be allocated.\84\ The term ``trading manager'' is defined in new Rule 4.10(h) as any person, other than the pool's CPO, with authority to allocate pool assets to CTAs or investee pools.\85\ Rule 4.25(c)(2) requires trading manager performance in addition to CPO performance if the pool has a trading manager. In such cases, the trading manager is, in effect, a supervisory CTA and the performance of such manager is clearly material. As discussed supra, the requirement has been changed from an alternate one, i.e., CPO or trading manager's performance, to include performance of both on the basis that even where a trading manager has been appointed, generally the CPO will continue to exercise ultimate control over the pool's operations. However, in cases where the trading manager has been given complete authority over the pool's trading and the performance of the trading manager does not differ materially from that of the pool operator, Rule 4.25(c)(2) provides that performance data for the pool operator may be omitted. \84\ See, e.g., Rule 4.25 (c)(2). \85\ As the Commission noted in the Proposing Release, the practice of retaining trading managers to select and monitor the performance of CTAs and investee pools to which pool assets will be committed has become commonplace. CPOs commonly seek to maximize pool returns by allocating pool assets based on analysis of the returns achieved by CTAs retained for the pool and investee pools in which the pool has invested in light of their aggregate results, market conditions, and the performance of other CTAs and investee pools. CPOs frequently rely on trading managers to continously review the performance of CTAs and investee pools and allocate and reallocate pool funds. Because of the importance of the trading manager and the fact that the trading manager is a CTA for the pool, when a pool has a trading manager, the trading manger's performance is generally required in addition to that of the CPO. 59 FR 25351, 25357. --------------------------------------------------------------------------- 2. Required Past Performance Disclosure in CTA Disclosure Documents: Rule 4.35 Proposed Rule 4.34(a)(1) would have required CTAs to continue to present past performance of the offered trading program in the full multi-columnar format required by former Rule 4.31(a)(3). Most commenters strongly urged that CTAs be permitted to use the new capsule format. Some argued that if the offered trading program's performance must be presented in the multi-column format, the CTA will be forced to produce a separate Disclosure Document for each program he offers or to include all past performance in the multi-columnar format. One commenter suggested permitting use of the capsule format for the CTA's offered trading program but requiring monthly rates of return. The Commission has determined to modify proposed Rule 4.34(a) to provide that the past performance of the CTA's offered trading program be presented in capsule format.\86\ The capsule will include the names of the CTA and the trading program, the dates on which the CTA began trading client accounts and on which accounts were first traded pursuant to the trading program, the number of accounts traded pursuant to the trading program, and the total assets under management by the CTA and total assets traded pursuant to the trading program. The worst monthly and peak-to valley draw-downs experienced by the trading program are also required. Like the offered pool's performance in a CPO Disclosure Document, the capsule for a CTA's offered program is required to include monthly rates of return. The offered trading program's monthly rates of return may be presented either in a table or in a bar graph or chart. (Rule 4.35(a)(2) (ii) and (iii)). The offered program's capsule must also include the number of accounts closed with positive net performance during the most recent five calendar years and year-to-date, as well as the number of accounts closed with negative net performance during the same period. (Rule 4.35(a)(1)(viii)). CTAs will be required to provide prospective and existing clients, upon request, with the offered trading program's performance in the multi- column format previously required. (Rule 4.35(a)(2)(iv)). \86\ With respect to CTAs calculating rates of return on the basis permitted by Advisory 93-13, as discussed supra, the capsule must include rates of return for the fully-funded subset and Commission staff will provide guidance concerning supplemental data to accompany the capsule disclosure to reflect the range of levels of partial funding and the generic disclosures discussed in Advisory 93-13. --------------------------------------------------------------------------- The Commission believes that with the specified additional requirements for the offered trading program, this modification of the proposal will result in simplified CTA Disclosure Documents, while providing prospective clients with material information regarding trading program volatility. 3. Time Period for Which Required Past Performance Disclosures Must Be Made: Rules 4.25(a)(5) for CPOs and 4.35(a)(5) for CTAs \87\ \87\ Former Rules 4.21 (a)(4) and (a)(5) for CPOs and 4.31(a)(3) for CTAs generally required past performance to be presented for a three-year period. --------------------------------------------------------------------------- Proposed Rules 4.25(a)(7) and 4.34(a)(4) would have extended the time period for which performance must be disclosed from three years to five years (or the life of the pool or account, if less than five years). As stated in the Proposing Release, the Commission believ [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A95-17871. Public record. Not legal advice.