Smith Barney Potomac Futures Fund L.P.
Notes to Financial Statements
September 30, 2005
(Unaudited)
In the normal course of its business, the Partnership either directly or through its investment in the Master, is party to financial instruments with off-balance sheet risk, including derivative financial instruments and derivative commodity instruments. These financial instruments may include forwards, futures and options, whose values are based upon an underlying asset, index, or reference rate, and generally represent future commitments to exchange currencies or cash flows, to purchase or sell other financial instruments at specific terms at specified future dates, or, in the case of derivative commodity instruments, to have a reasonable possibility to be settled in cash, through physical delivery or with another financial instrument. These instruments may be traded on an exchange or over-the-counter ("OTC"). Exchange-traded instruments are standardized and include futures and certain option contracts. OTC contracts are negotiated between contracting parties and include forwards and certain options.
Each of these instruments is subject to various risks similar to those related to the underlying financial instruments including market and credit risk. In general, the risks associated with OTC contracts are greater than those associated with exchange-traded instruments because of the greater risk of default by the counterparty to an OTC contract.
Market risk is the potential for changes in the value of the financial instruments traded by the Partnership/Master due to market changes, including interest and foreign exchange rate movements and fluctuations in commodity or security prices. Market risk is directly impacted by the volatility and liquidity in the markets in which the related underlying assets are traded.
Credit risk is the possibility that a loss may occur due to the failure of a counterparty to perform according to the terms of a contract. Credit risk with respect to exchange-traded instruments is reduced to the extent that an exchange or clearing organization acts as a counterparty to the transactions. The Partnership's/Master's risk of loss in the event of counterparty default is typically limited to the amounts recognized as unrealized appreciation in the statements of financial condition and not represented by the contract or notional amounts of the instruments. The Partnership, through its investment in the Master, has credit risk and concentration risk because the sole counterparty or broker with respect to the Master's assets is CGM.
The General Partner monitors and controls the Partnership's/Master's risk exposure on a daily basis through financial, credit and risk management monitoring systems, and accordingly believes that it has effective procedures for evaluating and limiting the credit and market risks to which the Partnership/Master is subject. These monitoring systems allow the General Partner to statistically analyze actual trading results with risk-adjusted performance indicators and correlation statistics. In addition, on-line monitoring systems provide account analysis of futures, forward and option positions by sector, margin requirements, gain and loss transactions and collateral positions.
The majority of these instruments mature within one year of September 30, 2005. However, due to the nature of the Partnership's/Master's business, these instruments may not be held to maturity.
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.
Liquidity and Capital Resources
The Partnership does not engage in the sale of goods or services. Its only assets are its investment in the Master and cash. The Master does not engage in the sale of goods or services. Because of the low margin deposits normally required in commodity futures trading, relatively small price movements may result in substantial losses to the Partnership. While substantial losses could lead to a substantial decrease in liquidity, no such losses occurred in the third quarter of 2005.
The Partnership's capital consists of capital contributions, as increased or decreased by its investment in the Master, expenses, interest income, redemptions of Redeemable Units and distributions of profits, if any.
For the nine months ended September 30, 2005, Partnership capital increased 27.9% from $154,682,645 to $197,896,165. This increase was attributable to a net gain from operations of $8,118,814 coupled with the additional sales of 40,326.7168 Redeemable units of Limited Partnership Interest totaling $68,522,000, which was partially offset by the redemption of 19,280.2399 Redeemable Units of Limited Partnership Interest totaling $33,427,294. Future redemptions can impact the amount of funds available for investment in commodity contract positions in subsequent periods.
The Master's capital consists of the capital contributions of the partners as increased or decreased by realized and/or unrealized gains or losses on commodity futures trading, expenses, interest income, redemptions of Units and distributions of profits, if any.
For the nine months ended September 30, 2005, Master's capital increased 8.2% from $283,959,300 to $307,364,082. This increase was attributable to a net gain from operations of $29,854,945 coupled with the additional sales of 331,976.6685 units totaling $333,375,300, which was partially offset by the redemption of 50,110.9402 units totaling $51,241,927 and distribution of interest totaling $4,624,236 to the limited partners of the Master. Future redemptions can impact the amount of funds available for investments in commodity contract positions in subsequent periods.
Critical Accounting Policies
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.
All commodity interests (including derivative financial instruments and derivative commodity instruments) are used for trading purposes. The commodity interests are recorded on trade date and open contracts are recorded in the statements of financial condition at fair value on the last business day of the period, which represents market value for those commodity interests for which market quotations are readily available or other measures of fair value deemed appropriate by management of the General Partner for those commodity interests and foreign currencies for which market quotations are not readily available. Investments in commodity interests denominated in foreign currencies are translated into U.S. dollars at the exchange rates prevailing on the last business day of the period. Realized gains (losses) and changes in unrealized values on open positions are recognized in the period in which the contract is closed or the changes occur and are included in net gains (losses) on trading of commodity interests.
The value of the Partnership's investment in the Master reflects the Partnership's proportional interest in the partners' capital of the Master. All of the income and expenses and unrealized and realized gains and losses from the commodity transactions of the Master are allocated pro rata among the investors at the time of such determination.
Foreign currency contracts are those contracts where the Partnership/Master agrees to receive or deliver a fixed quantity of foreign currency for an agreed-upon price on an agreed future date. Foreign currency contracts are valued daily, and the Partnership's/Master's net equity therein, representing unrealized gain or loss on the contracts as measured by the difference between the forward foreign
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exchange rates at the dates of entry into the contracts and the forward rates at the reporting date, is included in the statements of financial condition. Realized gains (losses) and changes in unrealized values on foreign currency contracts are recognized in the period in which the contract is closed or the changes occur and are included in the Statements of Income and Expenses and Partners' capital.
Results of Operations
During the Partnership's third quarter of 2005 the net asset value per Redeemable unit decreased 2.0% from $1,801.96 to $1,766.18 as compared to a decrease of 4.1% in the third quarter of 2004. The Partnership experienced a net trading loss before brokerage commissions and related fees in the third quarter of 2005 of $639,291. Losses were primarily attributable to the trading of commodity futures in currencies and U.S. and non-U.S. interest rates and were partially offset by gains in energy, metals and indices. The Partnership experienced a net trading loss before brokerage commissions and related fees in the third quarter of 2004 of $2,996,026. Losses were primarily attributable to the trading of commodity futures in currencies, energy, indices and metals and were partially offset by gains in U.S. and non-U.S. interest rates.
Third Quarter results reflect strong trends and profitable trading in the energy and stock index markets which were offset by losses in interest rates and currencies. Periodic trading opportunities in metals, grains and softs generated small gains for the partnership. The overall net result was slightly positive for the quarter.
The quarter started with reversing trends in U.S. and European fixed income instruments as yields began to rise, prompted by U.S. central bank rate increases. This volatility continued through the remainder of the quarter and led to the greatest sector loss for the partnership. The most profitable trends for the quarter, however, were in the energy markets as crude oil and natural gas prices rose to historic levels. Substantial profits were made in trading these markets which saw recent trends exacerbated by the impact of the two Gulf Coast hurricanes.
Prospects of improving economic conditions in Japan led to strong profits in Nikkei stock index trading and combined with solid second quarter corporate profits led to profits in U.S. stock index trading as well. Offsetting profitable stock index trading were losses in foreign currency trading. The most notable event in this markets was the Chinese government decision to unpeg the yuan from the U.S. dollar and its consequent upward revaluation. This led to near continuous adjustments in the relation of the major currencies throughout the quarter and range-bound trading in the U.S. dollar. While other commodity markets produced lackluster price trends, precious metals, particularly gold rose to over $400 an ounce, its highest level in 15 years and produced additional profits for the partnership's advisors.
During the Partnership's nine months ended September 30, 2005 the net asset value per Redeemable unit increased 3.9% from $1,699.79 to $1,766.18 as compared to a decrease of 3.8% for the nine months ended September 30, 2004. The Partnership experienced a net trading gain before brokerage commissions and related fees during the nine months ended September 30, 2005 of $17,381,589. Gains were primarily attributable to the trading of commodity futures in currencies, energy, non-U.S. interest rates, metals and indices and were partially offset by losses in U.S. interest rates. The Partnership experienced a net trading gain before brokerage commissions and related fees for the nine months ended September 30, 2004 of $4,578,894. Gains were primarily attributable to the trading of commodity futures in energy and U.S. and non-U.S. interest rates and were partially offset by losses in currencies, metals and indices.
Commodity futures markets are highly volatile. The potential for broad and rapid price fluctuations increases the risks involved in commodity trading, but also increases the possibility of profit. The profitability of the Partnership (and the Master) depends on the existence of major price trends and the ability of the Advisor to correctly identify those price trends. Price trends are influenced by, among other things, changing supply and demand relationships, weather, governmental, agricultural, commercial and trade programs and policies, national and international political and economic events and changes in interest rates. To the extent that market trends exist and the Advisor is able to identify them, the Partnership (and the Master) expects to increase capital through operations.
Interest income on 80% of the Partnership's daily average equity allocated to it by the Master was earned at a 30-day U.S. Treasury bill rate determined weekly by CGM based on the average
16
non-competitive yield on 3-month U.S. Treasury bills maturing in 30 days. CGM may continue to maintain the Master's assets in cash and/or place all of the Master's assets in 90-day Treasury bills and pay the Partnership 80% of the interest earned on the Treasury bills purchased. CGM will retain 20% of any interest earned on Treasury bills. Interest income allocated from the Master for the three and nine months ended September 30, 2005 increased by $920,396 and $2,214,263, respectively as compared to the unallocated amount earned directly for the corresponding periods in 2004. The increase in interest income is primarily due to higher net assets and higher interest rates during the three and nine months ended September 30, 2005 as compared to the corresponding periods in 2004.
Brokerage commissions are calculated on the Partnership's adjusted net asset value on the last day of each month and are affected by trading performance, additions and redemptions. Accordingly, they must be analyzed in relation to the fluctuations in the monthly net asset values. Commissions and fees for the three and nine months ended September 30, 2005 increased by $1,146,262 and $2,772,791, respectively as compared to the corresponding periods in 2004. The increase in brokerage commissions and fees is due to higher net assets during the three and nine months ended September 30, 2005 as compared to the corresponding periods in 2004.
Management fees are calculated as a percentage of the Partnership's net asset value as of the end of each month and are affected by trading performance, additions and redemptions. Management fees for the three and nine months ended September 30, 2005 increased by $363,817 and $899,977, respectively as compared to the corresponding periods in 2004. The increase in management fees is due to higher net assets during the three and nine months ended September 30, 2005 as compared to the corresponding periods in 2004.
Incentive fees are based on the new trading profits generated by the Advisor at the end of the quarter as defined in the advisory agreements between the Partnership, the General Partner and the Advisor. There were no incentive fees earned for the three and nine months ended September 30, 2005 as well as the three months ended September 30, 2004. Trading performance for the nine months ended September 30, 2004 resulted in incentive fees of $3,973,895.
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Item. 3 Quantitative and Qualitative Disclosures about Market Risk
All of the Partnership's assets are subject to the risk of trading loss through its investment in the Master. The Master is a speculative commodity pool. The market sensitive instruments held by it are acquired for speculative trading purposes, and all or substantially all of the Master's assets are subject to the risk of trading loss. Unlike an operating company, the risk of market sensitive instruments is integral, not incidental, to the Master's main line of business.
Market movements result in frequent changes in the fair market value of the Master's open positions and, consequently, in its earnings and cash flow. The Master's market risk is influenced by a wide variety of factors, including the level and volatility of interest rates, exchange rates, equity price levels, the market value of financial instruments and contracts, the diversification effects among the Master's open positions and the liquidity of the markets in which it trades.
The Master rapidly acquires and liquidates both long and short positions in a wide range of different markets. Consequently, it is not possible to predict how a particular future market scenario will affect performance, and the Master's past performance is not necessarily indicative of its future results.
Value at Risk is a measure of the maximum amount which the Master could reasonably be expected to lose in a given market sector. However, the inherent uncertainty of the Master's speculative trading and the recurrence in the markets traded by the Master of market movements far exceeding expectations could result in actual trading or non-trading losses far beyond the indicated Value at Risk or the Master's experience to date (i.e., "risk of ruin"). In light of the foregoing as well as the risks and uncertainties intrinsic to all future projections, the inclusion of the quantification in this section should not be considered to constitute any assurance or representation that the Master's losses in any market sector will be limited to Value at Risk or by the Master's attempts to manage its market risk.
Exchange maintenance margin requirements have been used by the Master as the measure of its Value at Risk. Maintenance margin requirements are set by exchanges to equal or exceed the maximum losses reasonably expected to be incurred in the fair value of any given contract in 95%-99% of any one-day interval. Maintenance margin has been used rather than the more generally available initial margin, because initial margin includes a credit risk component, which is not relevant to Value at Risk.
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The following table indicates the trading Value at Risk associated with the Master's open positions by market category as of September 30, 2005 and the highest, lowest and average values during the three months ended September 30, 2005. All open position trading risk exposures of the Master have been included in calculating the figures set forth below. As of September 30, 2005, the Master's total capitalization was $307,364,082.
September 30, 2005
(Unaudited)
| | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | Three Months ended September 30, 2005 |
| Market Sector | | Value at Risk | | % of Total
Capitalization | | High
Value at Risk | | Low
Value at Risk | | Average
Value at Risk* |
| Currencies: | | | | | | | | | | | | | | | | | | | | |
| — OTC | | $ | 12,036,735 | | | | 3.92 | % | | $ | 15,471,864 | | | $ | 12,036,735 | | | $ | 13,025,376 | |
| Energy | | | 1,366,675 | | | | 0.44 | % | | | 4,369,900 | | | | 1,220,252 | | | | 2,510,348 | |
| Interest Rates U.S. | | | 2,851,200 | | | | 0.93 | % | | | 4,653,750 | | | | 60,349 | | | | 3,362,157 | |
| Interest Rates Non-U.S. | | | 1,971,466 | | | | 0.64 | % | | | 6,700,981 | | | | 1,451,310 | | | | 2,528,053 | |
| Metals | | | | | | | | | | | | | | | | | | | | |
| — OTC | | | 333,800 | | | | 0.11 | % | | | 663,775 | | | | 271,900 | | | | 350,667 | |
| Indices | | | 10,041,158 | | | | 3.27 | % | | | 13,303,963 | | | | 7,756,953 | | | | 10,415,897 | |
| Total | | $ | 28,601,034 | | | | 9.31 | % | | | | | | | | | | | | |
|
| |
| * Average of Month-end Values at Risk |
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Item 4. Controls and Procedures
The General Partner of the Partnership, with the participation of the General Partner's Chief Executive Officer and the Chief Financial Officer, has evaluated the effectiveness of the design and operation of its disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) with respect to the Partnership as of the end of the period covered by the report, and based on this evaluation, has concluded that these disclosure controls and procedures are effective. Additionally, there were no significant changes in the Partnership's internal controls or in other factors that could significantly affect these controls during the registrant's last fiscal quarter, including any corrective actions with regard to significant deficiencies and material weaknesses.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
The following information supplements and amends our discussion set forth under Item, 3 "Legal Proceedings" in the Partnership's Annual Report on Form 10-K for the year ended December 31,2004 and under Part II, Item 1, "Legal Proceedings" in the Partnership's Quarterly Reports on Form 10-Q for the quarters ended March 31, 2005 and June 30, 2005.
Enron Corp.
On August 4, 2005, a breach of contract action was filed in the United States District Court for the Southern District of New York, WESTPAC BANKING CORPORATION v. CITIBANK, N.A. The complaint alleges that Citibank breached a representation and warranty in a Credit Default Swap agreement entered into in December 2000 concerning Enron.
On August 26, 2005, a group of 15 plaintiffs filed an action in the United States District Court for the Southern District of Texas, AVENUE CAPITAL MANAGEMENT II, L.P., ET AL. v. J.P. MORGAN-CHASE & CO., ET AL. The complaint names as defendants Citigroup Inc., Citibank, N.A., Citigroup Global Markets Inc., and several J.P. Morgan entities and alleges fraud, breach of fiduciary duty and breach of contract arising out of Enron bank debt incurred under two syndicated revolving credit facilities and a syndicated letter of credit facility.
WorldCom, Inc.
In STURM, ET AL. v. CITIGROUP, ET AL., an NASD arbitration seeking very significant compensatory and punitive damages, Claimants' common law claims, including fraud, arising out of alleged research analyst conflicts of interest related to SSB research coverage of WorldCom, were heard this quarter.
Citigroup, along with other financial institution defendants, entered into a settlement in NEW YORK CITY EMPLOYEES' RETIREMENT SYSTEM v. EBBERS, ET AL., resolving all claims against the Citigroup-related defendants in this WorldCom-related action, which was brought by a plaintiff that opted out of the settlement of the WorldCom class action. The settlement amount is covered by existing litigation reserves.
Citigroup along with other financial institutions and other defendants, entered into a settlement resolving all claims against the Citigroup-related defendants in 32 individual actions filed by a single law firm on behalf of 70 institutional plaintiffs that have opted out of the WorldCom class action settlement. Plaintiffs in these actions asserted various claims under federal and state law, including, among other things, federal and state securities claims, fraud, negligent misrepresentation and breach of fiduciary duty, in connection with the Citigroup-related defendants' research coverage, and underwriting of WorldCom securities. The settlement amount is covered by existing litigation reserves.
Global Crossing
On September 12, 2005, Citigroup entered into a settlement with the Global Crossing Estate Representative, resolving all claims pending in United States Bankruptcy Court for the Southern District of New York against the Citigroup-related defendants. The settlement amount is covered by existing litigation reserves.
Research
On September 27, 2005, Citigroup entered into a memorandum of agreement settling all claims against the Citigroup-related defendants in IN RE SALOMON ANALYST AT&T LITIGATION, a putative class action alleging research analyst conflicts of interest. The settlement amount is covered by existing litigation reserves. The settlement is subject to judicial approval.
On September 22, 2005, Citigroup reached an agreement-in-principle to settle all claims against the Citigroup-related defendants in NORMAN v. SALOMON SMITH BARNEY, ET AL., a putative class action asserting violations of the Investment Advisers Act of 1940 and various common law claims in connection with certain investors who maintained guided portfolio management accounts at Smith Barney. The settlement amount is covered by existing litigation reserves. The settlement is subject to judicial approval.
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On August 17, 2005, in DISHER v. CITIGROUP GLOBAL MARKETS INC., the United States Court of Appeals for the Seventh Circuit reversed the district court's grant of plaintiffs' motion to remand the case to state court, and directed the district court to dismiss the case as preempted under the Securities Litigation Uniform Standards Act ("SLUSA"). The United States Supreme Court has granted review in another case involving SLUSA that may affect the Seventh Circuit's dismissal of the Disher matter.
Adelphia
In May and July of 2005, the United States District Court for the Southern District of New York granted motions to dismiss several claims, based on the running of applicable statute of limitations, asserted in the putative class and individual actions being coordinated under IN RE ADELPHIA COMMUNICATIONS CORPORATION SECURITIES AND DERIVATIVE LITIGATION. With the exception of one individual action that was dismissed with prejudice, the court granted the putative class and individual plaintiffs leave to re-plead certain of those claims the court found to be time-barred. Additional motions to dismiss the class complaint and the remaining individual complaints on other grounds remain pending.
IPO Securities Litigation
On June 30, 2005, the United States Court of Appeals for the Second Circuit entered an order in IN RE INITIAL PUBLIC OFFERING SECURITIES LITIGATION agreeing to review the district court's order granting plaintiffs' motion for class certification.
IPO Antitrust Litigation
On September 28, 2005 the United States Court of Appeals for the Second Circuit in IN RE INITIAL PUBLIC OFFERING ANTITRUST LITIGATION vacated the district court's order dismissing these actions and remanded for further proceedings.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
For the three months ended September 30, 2005, there were additional sales of 14,942.3262 Redeemable Units of Limited Partnership totaling $26,262,000. The Redeemable Units were issued in reliance upon applicable exemptions from registration under Section 4(2) of the Securities Act of 1933, as amended, and Section 506 of Regulation D promulgated thereunder.
Proceeds from the sale of additional Redeemable Units are used in the trading of commodity interests including futures contracts, options and forwards contracts.
The following chart sets forth the purchases of Redeemable Units by the Partnership.
| | | | | | | | | | | | | | | | | | |
| Period | | (a) Total Number
of Shares
(or Units) Purchased* | | (b) Average
Price Paid per
Share (or Unit)** | | (c) Total Number
of Shares (or Units)
Purchased as Part
of Publicly Announced
Plans or Programs | | (d) Maximum Number
(or Approximate
Dollar Value) of Shares
(or Units) that
May Yet Be
Purchased Under the
Plans or Programs |
July 1, 2005 -
July 31, 2005 | | | 2,787.3106 | | | $ | 1,810.74 | | | | N/A | | | | N/A | |
August 1, 2005 -
August 31, 2005 | | | 3,274.4304 | | | $ | 1,717.13 | | | | N/A | | | | N/A | |
September 1, 2005 -
September 30, 2005 | | | 7,450.8000 | | | $ | 1,766.18 | | | | N/A | | | | N/A | |
| Total | | | 13,512.5410 | | | $ | 1,764.68 | | | | N/A | | | | N/A | |
|
| |
| * Generally, Limited Partners are permitted to redeem their Redeemable Units as of the end of each month on 10 days' notice to the General Partner. Under certain circumstances, the General Partner can compel redemption but to date the General Partner has not exercised this right. Purchases of Redeemable Units by the Partnership reflected in the chart above were made in the ordinary course of the Partnership's business in connection with effecting redemptions for Limited Partners. |
| |
| ** Redemptions of Redeemable Units are effected as of the last day of each month at the Net Asset Value per Redeemable Unit as of that day. |
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Item 3. Defaults Upon Senior Securities – None
Item 4. Submission of Matters to a Vote of Security Holders – None
Item 5. Other Information – None
Item 6. Exhibits
The exhibits required to be filed by Item 601 of Regulation S-1 are incorporated herein by reference to the exhibit index of the Annual Report on Form 10-K for the period ended December 31, 2004.
Exhibit - 31.1 - Rule 13a-14(a)/15d-14(a) Certification
(Certification of President and Director)
Exhibit – 31.2 – Rule 13a-14(a)/15d-14(a) Certification
(Certification of Chief Financial Officer and Director)
Exhibit – 32.1 – Section 1350 Certification
(Certification of President and Director).
Exhibit – 32.2 – Section 1350 Certification
(Certification of Chief Financial Officer and Director).
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
| | | | | | |
| SMITH BARNEY POTOMAC FUTURES FUND L.P. |
| By: | | Citigroup Managed Futures LLC
(General Partner) |
| By: | | /s/ David J. Vogel
David J. Vogel,
President and Director |
| Date: November 9, 2005 |
| By: | | /s/ Daniel R. McAuliffe, Jr.
Daniel R. McAuliffe, Jr.
Chief Financial Officer and Director |
| Date: November 9, 2005 |
|
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