Do you trade commodity futures, options or swaps with a partner or a group of partners? If so, you need to know if your business model is properly described as a commodity pool or as a proprietary trading firm. The answer is not always clear and the regulatory guidance is very limited. The answer is important in determining whether your business is subject to CFTC and NFA registration and regulatory requirements. It’s also important because your clearing broker will want to know who its customer is, and may refuse to hold your account if the clearing broker believes you are a pool operator that has failed to register (or claim an applicable exemption).
By way of example, assume John and Jane are both employed as traders for Oldco. They decide to open their own trading shop, Newco. Their budget is tight but John’s Dad has a deep pocket, and he offers to bankroll Newco by investing $1 million. John and Jane agree to handle all of the trading decisions. John, Dad, and Jane each own one-third of Newco and will share profits equally. Leaving aside registration exemptions that might be available, what is the nature of this enterprise: Is it a commodity pool or a proprietary trading firm?
CFTC Rule 4.10(d)(1) defines “pool” as “any investment trust, syndicate or similar form of enterprise operated for the purpose of trading commodity interests.” (Italics added). The regulations do not define “investment trust” or “syndicate.” However, an “investment trust” may be defined as a closed-end fund established to produce income through investments.” Webster’s describes “syndicate” as “a group of persons … who combine to carry out a particular transaction.” To most lawyers, in common usage, reference to a “pool” or a “fund” speak to an investment vehicle in which (a) an ongoing offering (typically private) occurs, (b) investors have liquidity in and out, (c) the investment is passive insofar as someone else runs the pool and the investor merely writes a check, and (d) whoever is running the pool receives fees from the investors. In contrast, the typical proprietary trading firm is a closely-held business that engages in speculative trading for its own account. It does not manage money for outsiders and does not act as an advisor in any capacity. Its business model is P&L driven, not fee driven.
Unfortunately, the ostensible clarity of the regulatory definition of “pool” is sometimes stretched by regulators in practice. In the context of routine regulatory exams and NFA Bylaw 1101 compliance, some futures commission merchants have reported regulatory insistence that any account beneficially owned by more than person must be treated as a “pool” unless there are two owners who are married. We respectfully disagree. The definition of “pool” does not state that a pool is any business that is owned by two or more people and trades commodity futures. If that were the case, one can imagine that the definition in Rule 4.10(d)(1) would simply be “A combination of two or more persons who trade commodity interests.” Instead, the phrase “or similar form of enterprise” clearly signifies that the business model must look like an “investment trust” or “syndicate” to fall within the definition of “pool.”
Here are several key considerations that could impact whether your trading firm is a “prop shop” or a pool:
Returning now to our hypothetical start-up, a starting point for analysis is whether Dad is merely a passive investor, or whether he is involved in management of the company. Let’s break it down:
If you have any questions about how to structure your trading operations, it’s best to consult with an attorney well versed in the legal and regulatory aspects of the financial markets.
Rick Reibman is a co-chair of Thompson Coburn's Corporate and Securities group and leads the practice in Chicago.