ASJ INTERNATIONAL, INC. Starting a Commodity Pool 32-1 Bergen Ridge Rd. North Bergen, NJ 07047 Phone: 201-724-9839 Fax: 201-868-6570 E-Mail: jfreed@asjinternational.com Web:
Starting a Commodity Pool 2 Starting a Commodity Pool by John Freed President, Copyright 2013 by does not offer legal advice and nothing in this document should be construed as being legal advice. The author has made every effort to provide up to date and accurate information, but it may be advisable to consult an attorney or the proper regulatory bodies. Trading futures and options is extremely risky and is not for everyone. No representation is made by this document regarding the appropriateness of derivative trading for anyone.
Starting a Commodity Pool 3 EXECUTIVE OVERVIEW Starting up a commodity pool is a difficult task that requires careful attention to detail. From raising money to complying with all regulations there is a lot to do even before you begin trading. This paper will give you an overview of the process and help you along the way. But you should not hesitate to speak to an attorney or to the NFA if you have any questions on how to proceed. SETTING UP THE BUSINESS The primary focus of setting up a commodity pool is profitable trading. But before trading can even begin a variety of activities must be completed. These activities include: Selecting a Corporate Structure Planning your Business Joining the NFA Registering employees with the NFA Documenting employee procedures (how will margin calls be handled, what reporting must be done and when, etc.) Contracting with an FCM (if the pool decides to do so) Opening client accounts Each of these steps can be quite complex, but all are important to the creation of a viable commodity pool operation.
Starting a Commodity Pool 4 SELECTING A CORPORATE STRUCTURE A commodity pool needs to create two or more business entities. The actual business owned by the commodity pool operators Each pool operated must be a separate business entity (NFA rule) Your business must be set up in such a way that the pool operator s personal assets are shielded (as much as possible) from a lawsuit filed against your firm. Additionally, taxes play a very important part in any decisions around which corporate structure to use. Typically the trading firm that is operating the pool(s) is set- up as one of the following entities: Limited Partnership (LLP) Limited Liability Company (LLC) C Corporation Subchapter S Corporations Here is a table providing an overview of each business type: Entity Control Liability Taxes Limited Partnership (LLP) A general partner controls the business General partners are fully liable for the businesses actions; limited partners have liability up to the amount of their investment Partnership files annual tax returns. All partners report their income on their personal tax return. Deductions for losses may be limited
Starting a Commodity Pool 5 Limited Liability Company (LLC) Members of an LLC can directly participate in the firm s management or they can elect a manager to run the company Owners are liable for business debts up to the amount they have invested Tax treatment varies by state C Corporation Shareholders appoint a board of directors which appoints officers who run the company Shareholders have liability up to the amount of their investment Company files its own tax return Subchapter S Shareholders appoint a board of directors which appoints officers who run the company Shareholders have liability up to the amount of their investment Shareholders report their share of the corporate profits or losses on their personal tax returns Determining which corporate structure to use is important and you should consult an attorney who is familiar with the issues surrounding trading businesses before making a decision. Once you have set- up the corporate structure of your firm, you need to decide what structure to use for the actual pool(s). NFA rules require that each pool be a separate legal entity. Managed futures businesses have traditionally set up the pools as LLPs, LLCs or C Corporations. However, there is a recent trend to set the pools up as trusts. Again, consult an attorney to help you make this decision.
Starting a Commodity Pool 6 PLANNING YOUR BUSINESS You need two documents to define how your trading business will be run: A Trading Plan A Business Plan You will need both a trading plan and a full business plan to get a loan or get an FCM to clear your business. The plans will also be reviewed by the NFA, so do not skip this step. A trading plan should include at least the following: How will you trade? Trend following? Spread trading? Scalping? Discretionary? Mechanical? Something else? What products will be traded? How will overnight trading be handled? How will risk management be handled? How will trades be allocated to client accounts? How will you clear trades? A business plan for a commodity pool should include at least the following things: What will your start up costs be? Do you have any intellectual property that needs legal protection? What fees will be charged to your clients? How will customer orders be taken (phone, email, online entry screen)? What expenses will the pool incur? Will the pool operator pay rent for office space? What about fees for data providers and trading platforms? Clearing costs and brokerage also need to be estimated. How long do you expect to operate before turning a profit? Do you have the capital required to survive until the fees you are collecting cover your expenses?
Starting a Commodity Pool 7 How will clerical work be handled (confirms, statements, regulatory filings, margin calls, trade reconciliation, etc.)? How will client redemptions be handled? Can clients transfer their ownership in the pool? Will the pool make periodic payments to the clients (capital gains distributions, dividends)? How will you market to prospective clients? How will marketing materials be checked for regulation violations before use? Will you conduct seminars, webinars, create a website, publish a newsletter, etc.? How will employees be educated and what is your plan for required ethics training? A proper business plan will be divided into a number of sections including: An Executive Summary Company description Customer analysis (who are your customers and how will you obtain new customers?) Management team Financial analysis (projected profits, cash flow, etc.) Legal organization (will your business be an LLC, LLP, corporation, etc.?
Starting a Commodity Pool 8 Charging Fees: There are three ways that the fees you charge your clients are typically arrived at: Management Fees - the pool operator is paid a percentage of the assets under management Incentive Fee - the pool operator is paid a percentage of net new trading profits Commissions - payment is based on the commissions generated. This is a conflict of interest concern and is rarely used today Note that incentive fees are based on "new net" profits. This means that if you make $50,000 in profits and charge an incentive fee, and then you lose $10,000, followed by making a profit of $12,000, you would only be able to charge an incentive fee on $2,000 of the $12,000 profit since $10,000 of that $12,000 profit is the recovery of money you had charged for earlier. Whatever fees you charge, you must fully disclose them to your clients. Be prepared to explain them clearly and in writing, and make sure your explanation appears in your customer disclosure document. JOINING THE NFA When you start a commodity pool, you are required to register with the NFA and the CFTC. There are a few exceptions to this requirement, but only very small pools qualify for them. Registration with the NFA is the first requirement. The NFA will then ensure that the CFTC Is notified properly of your registration. The following things must be done to register with the NFA: Complete the NFA registration documents electronically in their Online Registration System (ORS) Pay a non-refundable application fee of $200 Pay membership dues of $750 for one year Pay an $85 application fee for each principal or associated person
Starting a Commodity Pool 9 Determine who in your firm is required to have a Series 3 license and make arrangements for them to take the test Prepare a disclosure document that must be approved by the NFA before any funds can be accepted from clients Online Registration A document can be printed from the NFA website that lists all the questions the pool operator must answer in the ORS system. Once this form has been filled in, transfer the information on it into ORS. The information you will be asked for by ORS for an individual application includes: Personal information (name, address, Social Security number, etc.) Exchange affiliation (if the person registering owns a "seat" on an exchange) Business mailing address Previous disciplinary or criminal disclosures Employment and education history Residential history Proficiency requirements (have you passed the Series 3, 30 or 34 exams? You also must have your fingerprints taken as part of your registration. This can be done at a bonding company, city hall, a securities exchange or at a police station. The NFA has a form that must be downloaded and used as part of the fingerprinting process. The information you will be asked for by ORS for a firm application includes: The business address Corporate structure (corporation, partnership, etc.) Holding company and branch office information (if any) Exchange affiliation (if any)
Starting a Commodity Pool 10 Disciplinary information Criminal disclosures Names and addresses of certain employees of the pool (compliance officer, arbitration contact, etc.) Disclosure Documents Preparing a disclosure document that the NFA accepts is critical, and difficult. You may want to consult an attorney to do it. The NFA's website contains a document called "Disclosure Documents - a Guide for CPOs and CTAs" that provides detailed instructions on how to do this. Note that the document contains a large amount of text that must be cut and pasted into your disclosure document with no changes whatsoever. Here is a high-level summary of what your disclosure document must contain: Risk Disclosure (cut and paste) Table of Contents An introduction that includes basic information about your business (company name, address, telephone number, etc.) Identify the firm's principals by name and provide the business background of the principals The name of the firm's FCM or Introducing Broker Risks specific to the pool's trading strategy and a full description of that strategy All fees that will be charged to clients Any conflicts of interests that the principals may have Any material litigation that the firm or principals are involved in Previous performance of the pool (if the pool is new it must be clearly stated that there is no previous performance information and you will have to disclose the principal's personal trading performance)
Starting a Commodity Pool 11 Client liability in the pool (can they lose more than their initial investment?) How will the pool fulfill margin requirements? Break-even analysis The minimum and maximum subscriptions that the pool permits What the pool's reporting requirements to the clients are Once the disclosure document is written, it must be submitted to the NFA for approval. Use the NFA's Electronic Disclosure Document Filing System to do this. Expect a response in about 14 days. If there are any deficiencies in the document you will need to correct them and re-submit the disclosure to the NFA. Once your disclosure document is approved you are not done with it. No document older than nine months can be given to a client. This means that you will need to update the disclosure statement periodically and re-submit it for approval. This is accomplished by sending two copies of the document to the NFA: One copy is completely "clean" (a normal document) The second copy must be marked up to show all deletions, additions and other changes Other NFA Requirements: Once you are registered there are on-going requirements you need to fulfill: You must appoint a "security officer" who will be responsible for controlling access to both internal computer systems (trading, accounting, etc.) and external systems (such as the NFA's system) You must designate a Compliance Officer who will review trading and account activity and oversee the firm's anti-money laundering program as well as interface with regulators and auditors After you have completed your registration, the NFA will offer an "educational visit" where they will review reporting and record keeping, the audit process, etc. Take advantage of this offer, as it will help avoid problems later.
Starting a Commodity Pool 12 If you need to speak with an NFA representative at any time, the phone number is 800-621-3570. The NFA has a branch in New York City at 120 Broadway, Suite 1125, NY., NY 110271. REGISTERING EMPLOYEES Certain employees need to be registered with the NFA: All principals of the pool Associated Persons - anyone who routinely deals with clients or solicits funds from them As part of the registration process the employee must either take the correct licensing exam or they must show that they have already passed the required licensing exam. Licensing Exams The exams that may need to be taken are: Series 3 register to take this test on FINRA s website. Traders and principals of the firm are required to pass this exam Series 31 Futures Managed Funds Exam this test is taken by anyone who limits their activity to soliciting funds from clients Series 30 Branch Manager Exam the branch manager of a pool must pass this exam Passing the Series 3 "covers" the requirements of the other exams. Taking the other exams does not eliminate the need to take the Series 3 if it would otherwise be required.
Starting a Commodity Pool 13 Also, under NFA rule 2-9 all registered employees are required to periodically attend ethics classes and you must have a plan for this in the company s employee manual. DOCUMENTING EMPLOYEE PROCEDURES Creating an employee procedure document is a good idea in general for your business. The document is also something that regulators may demand to see when reviewing your office procedures for rule compliance. This document should include written procedures for (among other things): Opening new accounts (including "know your client" and "anti- money laundering" rule compliance) Updating the risk disclosure document and providing it to clients Handling margin calls Handling client money (segregation of funds, etc.) Dealing with clearinghouse breaks, etc. Delivering statements and confirms to clients Processing customer redemptions T racking performance, which must be included in customer and compliance reporting, as well as in updated versions of the disclosure document Complying with all regulations (preventing account "churning", etc.) The pool operators may contract with a third party (an FCM for example) to handle some of this, but the procedure manual then
Starting a Commodity Pool 14 would need to detail how the pool will work with the FCM to satisfy these requirements. CONTRACTING WITH AN FCM Choosing an FCM is one of the most important decisions a pool operator will make. Not only do you need to be comfortable working with the people in your FCM, but you must also be comfortable with their finances. Pool operators that did business with MF Global report that they lost from ten to fifty percent of their customers as a result of the events surrounding that FCM s failure. The NFA now posts certain financial information about FCMs on their website and this information should be referred to by the pool operator. FCMs will do much of the regulatory reporting, send out customer confirms and statements, handle margin calls and funds segregation and clear the pool's trades, among other things. Fees charged by the FCM are negotiable and may depend on things such as: the products and exchanges the pool trades how many trades the pool does over a certain period of time i f you have a less than clean regulatory record, expect the FCM to charge more, if they will even accept your business. Some FCMs might require that you use their trading platform or that you post a security deposit before trading starts. Make sure that everything is spelled out in the contract they offer.
Starting a Commodity Pool 15 OPENING CLIENT ACCOUNTS There are a large number of regulations that must be complied with when opening customer accounts: Provide an NFA approved disclosure document to each account holder before they actually open the account (and have the client sign a document stating that they received the disclosure document) Obtain the client's true name, address, and occupation as well as the name of the customer's employer Record the customer's marital status and the number of dependents they have Obtain the client's income, liquid net worth and full net worth Record the age of an individual client Get details of the customer's previous futures trading experience Ask the customer if the account is for speculative or hedging purposes and determine what the customer's risk tolerance is Have the client sign any required powers of attorney or discretionary trading authorizations Verbally obtained information must be sent to the client for them to review for accuracy. If the client provides the information in writing, it does not need to be sent back to the client for review. A principal, branch manager or other designated employee must review a ll account applications to decide if the account will be permitted to begin trading. Keep in mind that all transactions recommended by the pool or executed by the pool's traders must be appropriate for that particular client. Also, the pool operator must be reasonably sure
Starting a Commodity Pool 16 that the client understands the risks and is financially capable of withstanding the risks. The pool may also want to establish a minimum size for a new account. Also remember that the pool operator must provide the following reports to investors each quarter: The fund's Net Asset Value (NAV) at the end of the quarter The change in value of the NAV from the last quarter The value of the investor's interest in the pool at quarter end Annual reports must be provided to each customer. AUDIT REQUIREMENTS You should expect to be audited by the NFA at least once every three years. Your first audit will be done very soon after you open for business. The audit has two primary goals: Ensure that the pool is keeping proper records that comply with CFTC and NFA rules Verify that your business is being run in an honest way and that clients are protected from fraud Note that the NFA may audit your FCM rather than auditing the pool directly. But you will still need to understand the audit process and be able to provide any information the auditors request. In preparation for an NFA audit you should make sure that your policy and procedures manual is up- to- date as it will be reviewed,
Starting a Commodity Pool 17 as will your compliance manual, your sales practices manual, and your anti- money laundering policy. The audit will focus on the following things: General information - registration questions and verification that you are not doing business with people / firms that are not registered with the NFA, but should be Disclosure documents Company records Customer complaints and advertising Fees and block order allocation Performance record testing Also, the NFA will send a "Self- Examination" document to you each year. This document must be answered in writing and any deficiencies uncovered must be addressed as quickly as possible. CONCLUSIONS Setting up any business requires planning and attention to detail. This is especially true for businesses being started in a highly regulated industry such as futures trading. Remember to use legal help where necessary and consult with the regulators whenever you are unsure about how to proceed. Once you have started the business and registered it with the NFA, it is time to confront the marketplace and deliver real value to your clients!
Starting a Commodity Pool 18 About is a financial services consulting firm that helps financial services companies with their order routing and data warehousing projects. We specialize in helping to reduce trading expenses and have been part of projects that have saved hundreds of millions of dollars in clearing, exchange and brokerage fees at several large investment banks. We also write business and technical specifications for information technology projects, provide project management services and design and conduct classes for the employees of financial services firms. We have extensive knowledge of futures, options and equity trading. 32-1 Bergen Ridge Rd. North Bergen, NJ. 07047 ASJ@asjinternational.com 32 Bergen Ridge Rd., Suite 1, North Bergen, NJ. 07047 BusinessResearch@asjinternational.com 201-724-9839