[Federal Register Volume 69, Number 199 (Friday, October 15, 2004)]
[Notices]
[Pages 61276-61280]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E4-2654]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-50497; File No. SR- NFA-2004-02]


Self-Regulatory Organizations; National Futures Association; 
Notice of Filing and Immediate Effectiveness of a Proposed Rule Change 
and Amendment No. 1 Thereto Adopting Interpretive Notice to Bylaw 1101 
and Compliance Rules 2-9 and 2-29

October 6, 2004.
    Pursuant to Section 19(b)(7) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-7 thereunder,\2\ notice is hereby given that 
on September 10, 2004, the National Futures Association (``NFA'') filed 
with the Securities and Exchange Commission (``Commission'') the 
proposed rule change as described in Items I, II, and III below, which 
Items have been prepared by NFA. On September 9, 2004, the NFA filed 
the proposed rule change with the Commodity Futures Trading Commission 
(``CFTC'') for approval. Pursuant to Section 19(b)(7)(B) of the Act,\3\ 
the proposed rule change may take effect upon approval by the CFTC. On 
September 28, 2004, NFA filed with the Commission Amendment No. 1 to 
the proposed rule change.\4\ The Commission is publishing this notice 
to solicit comments on the proposed rule change, as amended, from 
interested persons.
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    \1\ 15 U.S.C. 78s(b)(7).
    \2\ 17 CFR 240.19b-7.
    \3\ 15 U.S.C. 78s(b)(7)(B).
    \4\ See letter from Kathryn Page Camp, Associate General 
Counsel, NFA, to John C. Roeser, Senior Special Counsel, Division of 
Market Regulation, Commission, dated September 28, 2004. Amendment 
No. 1 makes minor technical changes to the proposed rule text.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    NFA proposes to adopt NFA Bylaw 1508 regarding securities futures 
agreements. The text of the proposed rule change appears below. New 
language is in italics.
* * * * *

NFA Bylaw 1101, Compliance Rules 2-9 and 2-29: Guidelines Relating to 
the Registration of Third-Party Trading System Developers and the 
Responsibility of NFA Members for Promotional Material That Promotes 
Third-Party Trading System Developers and Their Trading Systems

    In recent years, there has been a significant increase in the 
number of futures trading systems being marketed to the public. These 
trading systems typically are computerized programs that generate 
signals as to when to buy and sell commodity futures and options 
contracts.
    A number of NFA Member firms offer trade execution services to 
customers who use these computerized trading systems, many of which are 
developed by third-party trading system developers (``third-party 
system developers''), who are neither NFA members nor registered with 
the CFTC. Typically, in these situations, the customer will execute a 
Letter of Direction that directs the Member to place trades for the 
customer in strict accordance with the signals generated by the trading 
system. In some cases, the Letter of Direction is more limited and 
includes instructions to follow only certain signals (e.g.,

[[Page 61277]]

signals in given contracts or signals that meet particular parameters). 
In almost all cases in which a Letter of Direction is used, the Member 
is not permitted to use any judgment when placing orders for the 
customer.
    This notice is designed to provide guidance as to the circumstances 
which may give rise to liability on the part of the Member, under NFA 
Bylaw 1101, for providing execution services to users of computerized 
trading systems developed by non-Member third-party system developers. 
This notice will also discuss the factors that may cause a Member to be 
responsible, under NFA Compliance Rule 2-29, for promotional material 
which promotes these trading systems and the Member's supervisory 
obligations under NFA Compliance Rule 2-9.

Registration Requirements for Third-Party System Developers

    Section 1a(6) of the Commodity Exchange Act (``CEA'') defines a CTA 
as any person who for compensation or profit, engages in the business 
of advising others, directly or through publications, writings, or 
electronic media, as to the value of or the advisability of trading 
commodity futures. Generally, Section 4m of the CEA requires 
individuals who fall within this definition to register with the CFTC. 
In March 2000, the CFTC adopted CFTC Rule 4.14(a)(9) to create an 
exemption from the CEA's registration requirements for CTAs that 
provide standardized advice by means of media such as newsletters, pre-
recorded telephone hotlines, Internet Web sites, and non-customized 
computer software.
    To qualify for the exemption, under Rule 4.14(a)(9)(i) a CTA may 
not direct client accounts. As defined by Commission Rule 4.10(f), 
``[d]irect, as used in the context of trading commodity interest 
accounts, refers to agreements whereby a person is authorized to cause 
transactions to be effected for a client's commodity interest account 
without the client's specific authorization.'' In a Commission Staff 
letter issued in May 2003, Commission Staff indicated that an agreement 
authorizing a person to direct a client's account--and, thus, requiring 
the person to be registered as a CTA--may be an informal agreement. The 
fact pattern addressed by the Commission's Staff letter involved a 
developer of a computerized trading system who was registered as an 
associated person (``AP'') of an introducing broker (``IB''). The AP's 
activities on behalf of the IB consisted solely of soliciting clients 
to use his trading program. Such clients executed a ``letter of 
direction'' providing that the IB should execute trades for the 
clients' accounts and ``follow [the trading program] signals as close 
as reasonably possible.''
    In analyzing the above fact pattern, Commission Staff concluded 
that, since the clients' contact with the AP/trading system developer 
included not only the trading program, but also the opening of a 
trading account that would be traded pursuant to a ``letter of 
direction,'' there was an ``informal arrangement'', for which the 
exemption provided under Rule 4.14(a)(9) was not intended. After 
specifically noting that the ``whole of [the AP/trading system 
developer's] activities as an AP of the IB consisted of the 
solicitation of clients for the trading program, CFTC staff determined 
that registration as a CTA was required of either the IB or the AP. 
(See CFTC staff letter, No. 03-26, May 30, 2003, re Section 4m--
Interpretation with regard to Commodity Trading Advisor Registration.)
    Rule 4.14(a)(9)(ii) also provides that, to qualify for the 
exemption, a CTA may not provide ``commodity trading advice based on, 
or tailored to, the commodity interest or cash market positions or 
other circumstances or characteristics of particular clients.'' So long 
as the CTA's advice is based on or tailored to such information, the 
CTA is required to register even if it gives the same advice to groups 
of similarly situated clients.
    In determining whether advice is ``based on or tailored to'' within 
the meaning of 4.14(a)(9)(ii), the context of the advice will be taken 
into account. For example, if the advice is provided in a book or a 
periodical, that factor may weigh against a finding that the CTA is 
providing advice ``based on or tailored to'' the characteristics of 
particular clients. On the other hand, if the advice is provided to a 
particular client in a face-to-face communication or over the 
telephone, that factor may weigh in favor of a finding that the CTA's 
advice is ``based on or tailored to'' that particular customer's 
characteristics, since such a context suggests that the CTA is being 
responsive to the client's individual needs.\1\
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    \1\ The Commission gives a number of examples, which illustrate 
the application of Rule 4.14(a)(9) in specific situations, in the 
Rule's publication in the . (Federal Register: March 10, 2000 
(Volume 65, Number 48, pages 12938-12943.)
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    Whether a third-party system developer is required to be registered 
as a CTA still depends on the particular facts of each case. In some 
cases, the third-party system developer--or any third-party, for that 
matter--may be required to register as an IB, if it refers customers to 
an NFA Member and receives compensation for the referrals. Members who 
have questions concerning the application of Rule 4.14 are urged to 
seek advice from the CFTC.
    Regardless of whether a third-party system developer is required to 
register as a CTA, the question sometimes arises whether the IBs 
involved must also register as CTAs. If the IB and the third-party 
system developer are operated as wholly independent entities and the IB 
has no authority to deviate from the third-party system developer's 
recommendations, generally the IB need not also register as a CTA. This 
is clearly the case where a customer independently selects a trading 
system and the IB does not solicit discretionary trading authority. 
However, if any of these factors change (e.g., the IB has authority to 
deviate from the trading system by selecting only some of the trades 
generated by the system), the IB may be required to register as a CTA, 
unless the IB is otherwise exempt because its activities related to 
placing trades based on the recommendations of the trading system are 
``solely in connection with its business as an IB.''
    NFA Bylaw 1101 provides, in pertinent part, that no Member may 
carry an account, accept an order or handle a transaction in commodity 
futures on behalf of any non-Member that is required to be registered 
as a CTA or in some other capacity. Therefore, if it appears that a 
third-party system developer, with whom an NFA Member does business, is 
required to be registered as a CTA or in some other capacity, the 
Member should request that the third-party system developer provide a 
letter from counsel stating the reasons why registration is not 
required.\2\ In the absence of such a letter, the Member should request 
that the third-party system developer apply for registration and NFA 
membership. If the third-party system developer fails or refuses to 
register and become an NFA Member, the Member should terminate its 
relationship with the third-party system developer to avoid liability 
under NFA Bylaw 1101.
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    \2\ Member firms may rely in good faith upon a copy of a letter 
from counsel. However, in some cases, a Member may have to perform 
additional due diligence to ascertain whether a third-party system 
developer is required to be registered.
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A Member's Responsibility for Misleading Promotional Material Which 
Promotes a Third-Party System Developer's Trading Program

    NFA has encountered, with increasing frequency in recent years, 
misleading promotional material promoting trading

[[Page 61278]]

systems developed by third-party system developers, who are not NFA 
Members, and for which an NFA Member provides trade execution services. 
Often this promotional material uses hypothetical or simulated 
results--which are trading results not achieved by an actual account--
that are not clearly identified as hypothetical and show impressive 
gains, when customers actually using the trading system have suffered 
substantial losses. In this and other contexts, both NFA and the 
Commission have brought numerous enforcement actions charging fraud in 
the use of such promotional material.
    Following are several examples of situations where Members may be 
held accountable under Compliance Rules 2-29 and 2-9 for misleading 
promotional material that promotes third-party trading system 
developers and their trading systems.

Direct Responsibility

    If an NFA Member or its Associates prepare or distribute the 
promotional material, the Member will be responsible for its misleading 
content under NFA Compliance Rule 2-29, which prohibits a Member from 
using misleading or deceptive promotional material.

Agency Responsibility

    NFA's Business Conduct Committee has always recognized that each 
Member is responsible for the acts of its agents. This certainly 
applies to the preparation of advertising material. Thus, an NFA Member 
may be responsible, under NFA Compliance Rule 2-29, for misleading 
promotional material prepared and disseminated by a third-party trading 
system developer, whether or not the third-party trading system 
developer is an NFA Member or not, if there is an agency relationship 
between the NFA Member and the third-party trading system developer. 
(Of course, if the third-party trading system developer is also an NFA 
Member, it too would be responsible under NFA Compliance Rule 2-29 for 
the misleading promotional material that it prepared and distributed.)
    In determining whether there is an agency relationship between the 
Member and the third-party system developer, which would trigger 
liability under NFA Compliance Rule 2-29, the central inquiry focuses 
on the nature of the business relationship between the parties and 
whether the parties have expressly or implicitly agreed that one may 
act for the other. As the CFTC has held, whether an agency relationship 
exists turns ``on an overall assessment of the totality of the 
circumstances in each case.'' The more limited the contacts are between 
the third-party system developer and the NFA Member, the more likely it 
is that an agency relationship will not be found to exist between the 
parties.
    If there is an agency relationship between the Member and the 
third-party system developer, then the Member has an affirmative duty, 
under NFA Compliance Rule 2-9, to supervise the activities of the 
third-party system developer/agent.

Supervisory Responsibility Under NFA Compliance Rule 2-9

    Even where no agency relationship exists, a Member whose web site 
links to or otherwise refers customers to a third-party system 
developer or has a referral agreement with a third-party trading system 
developer should conduct a due diligence inquiry into the system 
developer's advertising practices with a view towards identifying and 
avoiding the misleading advertising practices described earlier, i.e., 
the use of exaggerated profit claims, and hypothetical or simulated 
results which are not clearly identified as hypothetical, or which show 
highly profitable performance when actual customers trading the system 
have sustained significant losses.\3\
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    \3\ See also NFA's interpretive notice entitled ``NFA Compliance 
Rule 2-9: Supervisory Procedures for E-Mail and the Use of Web 
Sites'' (9037).
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    The fact that a Member creates a hyperlink from its web site or 
otherwise refers customers to a third-party system developer or has a 
referral agreement with a third-party system developer does not, in and 
of itself, make the Member firm accountable for the third-party system 
developer's web site or promotional material. Member firms should bear 
in mind, though, that their supervisory obligations under Rule 2-9 and 
Rule 2-29 require them to diligently supervise their employees and 
agents who are responsible for creating and maintaining hyperlinks to 
web sites of third-party system developers; or establishing referral 
agreements with third-party system developers. Members should consider 
whether appropriate supervisory procedures include periodic inquiries 
as to whether their employees and agents are conducting due diligence 
with respect to the third-party system developer's web site or 
advertising, and taking appropriate steps if deficiencies are found in 
such web site or advertising. A Member's failure to supervise its 
employees and agents in this regard will constitute a violation of NFA 
Compliance Rule 2-9 on the part of the Member. Moreover, in these 
situations, Member firms should not seek to circumvent NFA's 
promotional material requirements by relying upon the unregistered 
status of the third-party trading system developer.
* * * * *

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, NFA has prepared statements 
concerning the purpose of, and basis for, the proposed rule change, and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. NFA has prepared summaries, set forth in Sections A, B, 
and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    In recent years, NFA has witnessed a growing number of futures 
trading systems being marketed to the public. Typically, these are 
computerized trading systems which are developed by third-party trading 
system developers (``third-party system developers''), who are not 
required to be registered with the CFTC or members of NFA. The proposed 
Interpretive Notice to NFA Bylaw 1101 and Compliance Rules 2-9 and 2-29 
provides guidance on two issues that NFA members face when they offer 
trade execution services to customers who use these computerized 
trading systems.
    NFA believes that the Interpretive Notice summarizes the 
registration requirements for commodity trading advisors (``CTA''). NFA 
Bylaw 1101 provides, in pertinent part, that no member may carry an 
account, accept an order or handle a transaction in commodity futures 
on behalf of any non-member that is required to be registered as a CTA 
or in some other capacity. This section of the Interpretive Notice is 
designed to assist members in complying with NFA Bylaw 1101 when they 
do business with third-party system developers.
    According to NFA, the Interpretive Notice also addresses members' 
potential responsibility under NFA Compliance Rules 2-9 and 2-29 for 
misleading promotional material that promotes these trading systems. 
Such promotional material often relies upon extremely favorable 
hypothetical results which are not clearly identified as hypothetical 
and which are dramatically

[[Page 61279]]

better than the actual performance of customers who have used the 
system, many of whom have sustained large losses. Pursuant to NFA 
Compliance Rule 2-29(c), a member firm is prohibited from using these 
types of hypothetical results unless it meets very stringent 
requirements, which non-member third-party system developers are not 
required to meet.
    For example, NFA recently reviewed a promotional piece used by a 
non-member third-party system developer to promote its trading system, 
which boasted of hypothetical annual rates of return ranging from 86.4% 
to 151.7%. In this particular case, the NFA member offering trade 
execution services for this system claimed that no customers had traded 
this system. Because the third-party system developer is a non-member, 
NFA was unable to determine whether any customers had actually used the 
trading system and, if so, whether their actual performance 
corresponded to the advertised favorable hypothetical returns. 
According to NFA, the CFTC has also been confronted with and taken 
action against third-party system developers that use misleading 
promotional material to promote their trading systems.
    The proposed Interpretive Notice reminds members that they will be 
directly responsible under NFA Compliance Rule 2-29 if the member or 
its Associates prepares or distributes misleading promotional material 
regarding a third-party system developer or its trading system. It also 
reminds members that they may be responsible for misleading promotional 
material prepared and disseminated by a third-party trading system 
developer if there is an agency relationship between the NFA member and 
the third-party trading system developer.
    Finally, the Interpretive Notice states that, even where no agency 
relationship exists, members have a supervisory obligation under NFA 
Compliance Rules 2-9 and 2-29 to diligently supervise their employees 
and agents who are responsible for creating and maintaining hyperlinks 
to web sites of or establishing referral agreements with third-party 
system developers. A member whose web site links to, or otherwise 
refers its customers to, a third-party system developer or who has a 
referral agreement with a third-party trading system developer should 
conduct a due diligence inquiry into the system developer's advertising 
practices.
2. Statutory Basis
    NFA believes that the proposed rule change is consistent with 
Section 15A(k) of the Act.\5\
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    \5\ 15 U.S.C. 78o-3(k).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    NFA believes that the proposed rule change will not impose any 
burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act and the Commodity Exchange Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants or Others

    NFA states that it worked with industry representatives in 
developing the proposed rule change. NFA did not, however, publish the 
proposed rule change to the membership for comment. NFA did not receive 
comment letters concerning the proposed rule change.
    In working with the industry, NFA staff discussed the proposed 
Interpretive Notice with NFA's Futures Commission Merchant (``FCM''), 
Introducing Broker (``IB''), and Commodity Pool Operator/Commodity 
Trading Advisors (``CPO/CTA'') Advisory Committees and with the Futures 
Industry Association (FIA) Law and Compliance Committee, and most of 
their suggestions were incorporated in the final version adopted by 
NFA's Board of Directors (``Board''). The IB and CPO/CTA Advisory 
Committees supported the Interpretive Notice. The FCM Advisory 
Committee and FIA's Law and Compliance Committee still have 
reservations about some of the language regarding members' supervisory 
responsibilities when linking to or entering into referral arrangements 
with third-party system developers.
    NFA's Board adopted the Interpretive Notice by a vote of 21 to 1 
with one abstention, concluding that the Interpretive Notice accurately 
describes members' responsibilities under NFA rules and provides needed 
guidance to members that deal with third-party system developers.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    The Commission notes that NFA's proposal will become effective upon 
approval by the CFTC. Within 60 days of the date of effectiveness of 
the proposed rule change, the Commission, after consultation with the 
CFTC, may summarily abrogate the proposed rule change and require that 
the proposed rule change be refiled in accordance with the provisions 
of Section 19(b)(1) of the Act.\6\
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    \6\ 15 U.S.C. 78s(b)(1). For purposes of calculating the 60-day 
abrogation period, the Commission considers the period to commence 
on September 28, 2004, the date NFA filed Amendment No. 1.
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IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Comments may be submitted by any of 
the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml);
     Send an e-mail to [email protected]. Please include 
File Number SR-NFA-2004-02 on the subject line.

Paper Comments

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609.
    All submissions should refer to File Number SR-NFA-2004-02. This 
file number should be included on the subject line if e-mail is used. 
To help the Commission process and review your comments more 
efficiently, please use only one method. The Commission will post all 
comments on the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). Copies of the submission, all subsequent amendments, 
all written statements with respect to the proposed rule change that 
are filed with the Commission, and all written communications relating 
to the proposed rule change between the Commission and any person, 
other than those that may be withheld from the public in accordance 
with the provisions of 5 U.S.C. 552, will be available for inspection 
and copying in the Commission's Public Reference Room. Copies of such 
filing also will be available for inspection and copying at the 
principal office of NFA. All comments received will be posted without 
change; the Commission does not edit personal identifying information 
from submissions. You should submit only information that you wish to 
make available publicly. All submissions should refer to File Number 
SR-NFA-2004-02 and should be submitted on or before November 5, 2004.


[[Page 61280]]


    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\7\
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    \7\ 17 CFR 200.30-3(a)(75).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. E4-2654 Filed 10-14-04; 8:45 am]
BILLING CODE 8010-01-P