commodity futures and options are based on quoted market prices for those futures and options. Fair values for all other financial instruments for which market quotations are not readily available are based on other measures of fair value deemed appropriate by the General Partner.
In the normal course of its business, the Partnership, 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. The Master may trade commodity options. Specific market movements of the commodities or futures contracts underlying an option cannot accurately be predicted. The purchaser of an option may lose the entire premium paid for the option. The writer, or seller, of an option has unlimited risk. 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 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 by the Master.
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 Master’s risk of loss in the event of counterparty default is typically limited to the amounts recognized 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 June 30, 2007. However, due to the nature of the Master’s business, these instruments may not be held to maturity.
Table of ContentsItem 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 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/Master. While substantial losses could lead to a substantial decrease in liquidity, no such losses occurred in the second quarter of 2007.
The Partnership’s capital consists of capital contributions, as increased or decreased by its investment in Master, expenses, interest income, redemptions of Redeemable Units and distributions of profits, if any.
For the six months ended June 30, 2007, Partnership capital decreased 5.6% from $229,858,247 to $217,037,862. This decrease was attributable to the redemption of 13,537.4298 Redeemable Units of Limited Partnership Interest totaling $24,839,375, which was partially offset by a net gain from operations of $9,623,990 coupled with additional sales of 1,319.4399 Redeemable Units totaling $2,395,000. Future redemptions can impact the amount of funds available for investment in the Master 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 six months ended June 30, 2007, the Master’s capital decreased 5.3% from $327,090,390 to $309,805,967. This decrease was attributable to the redemption of 33,902.5125 units totaling $41,140,137 and distribution of interest totaling $5,775,553 to the limited partners of the Master, which was partially offset by a net gain from operations of $26,534,939 coupled with the additional sales of 2,595.2403 Units totaling $3,096,328. Future redemptions can impact the amount of funds available for investment in commodity contract positions in subsequent periods.
Critical Accounting Policies
The preparation of financial statements in conformity with U.S. generally accepted accounting principles 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 of the Master (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, including certain option contracts. 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 gains (losses) on open positions are recognized in the period in which the contr act 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 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 Master’s net equity therein, representing unrealized gain or loss on the contracts as measured by the difference between the forward foreign 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
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Table of ContentsCondition. Realized gains (losses) and changes in unrealized gains (losses) 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.
In July 2006, the Financial Accounting Standards Board (the ‘‘FASB’’) released FASB Interpretation No. 48 ‘‘Accounting for Uncertainty in Income Taxes’’ (FIN 48). FIN 48 provides guidance for how uncertain tax positions should be recognized, measured, presented and disclosed in the financial statements. FIN 48 requires the evaluation of tax positions taken or expected to be taken in the course of preparing the Partnership’s tax returns to determine whether the tax positions are ‘‘more-likely-than-not’’ of being sustained by the applicable tax authority. Tax positions not deemed to meet the more-likely-than-not threshold would be recorded as a tax benefit or expense in the current year. The Partnership adopted FIN 48 as of January 1, 2007 and the application of this standard did not impact the financial statements.
In September 2006, the FASB issued Statement of Financial Accounting Standards (‘‘SFAS’’) No. 157, FAIR VALUE MEASUREMENTS. This accounting standard establishes a single authoritative definition of fair value sets out a framework for measuring fair value and expands disclosures about fair value measurements. SFAS No. 157 applies to fair value measurements already required or permitted by existing standards. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and the interim periods within those fiscal years. As of June 30, 2007, the Partnership is still evaluating the impact the adoption of SFAS No. 157 will have on the financial statement amounts; however, additional disclosures will be required about the inputs used to develo p the measurements and the effect of certain measurements on changes in Partners’ Capital for the period.
Results of Operations
During the Partnership’s second quarter of 2007 the Net Asset Value per Redeemable Unit increased 12.6% from $1,715.42 to $1,931.02 as compared to a decrease of 7.0% in the second quarter of 2006. The Partnership experienced a net trading gain (comprised of realized gains (losses) on closed positions allocated from Master and change in unrealized gains (losses) on open positions allocated from Master) before brokerage fees and related fees in the second quarter of 2007 of $28,245,003. Gains were primarily attributable to the trading of commodity futures in currencies, U.S. and non-U.S. interest rates and indices and were partially offset by losses in energy and metals. The Partnership experienced a net trading loss before brokerage fees and related fees in the second quarter of 2006 of $15,873,931. Losses were primarily attributable to the trading of commodity futures in currencies and indices and were partially offset by gains in energy, U.S. and non-U.S. interest rates and metals.
The second quarter of 2007 presented a favorable trading environment, as trends emerged in several sectors, most notably in fixed income, stock indices and currencies. Inflationary pressures remained high in several economies as they continued to show strong growth characteristics and resilience even as the central banks increased the interest rates or kept them high relative to recent past. The Partnership registered minor losses in trading energy and metals and posted gains in currencies, fixed income and stock indices.
In the currency market, strong trends emerged as Japanese Yen weakened relative to U.S. Dollar. The Partnership was favorably positioned to register gains by capturing this trend through the quarter. Trading was also profitable in British Pound and New Zealand Dollar. In the fixed income sector, gains were realized as the economic data suggested continued growth and elevated inflationary pressures in several major world economies. As the global stock indices continued to reach new record levels, the Partnership was favorably positioned to profit from the long term trends in this sector.
Minor losses were realized in energy sector due to crude and heating oil positions. Trading in metals was also not profitable as minor losses were registered in gold and zinc.
During the Partnership’s six months ended June 30, 2007 the Net Asset Value per Redeemable Unit increased 4.7% from $1,844.57 to $1,931.02 as compared to a decrease of 3.1% for the six months ended June 30, 2006. The Partnership experienced a net trading gain (comprised of realized gains (losses) on closed positions allocated from Master and change in unrealized gains (losses) on open positions allocated
16
Table of Contentsfrom Master) before brokerage fees and related fees for the six months ended June 30, 2007 of $15,076,148. Gains were primarily attributable to the trading of commodity futures in currencies, indices and non-U.S. interest rates and were partially offset by losses in energy, U.S. interest rates and metals. The Partnership experienced a net trading loss before brokerage fees and related fees during the six months ended June 30, 2006 of $1,047,072. Losses were primarily attributable to the trading of commodity futures in currencies and non-U.S. interest rates and were partially offset by gains in indices, energy, metals and U.S. interest rates.
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 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 six months ended June 30, 2007 decreased by $432,209 and $337,700 as compared to the corresponding periods in 2006. The decrease in interest income is primarily due to lower net assets during the three and six months ended June 30, 2007 as compared to the corresponding periods in 2006.
Brokerage fees 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. Brokerage and fees for the three and six months ended June 30, 2007 decreased by $654,169 and $1,069,092 as compared to the corresponding periods in 2006. The decrease in brokerage and fees is due to lower net assets during the three and six months ended June 30, 2007 as compared to the corresponding periods in 2006.
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 six months ended June 30, 2007 decreased by $200,137 and $326,176 as compared to the corresponding periods in 2006. The decrease in management fees is due to lower net assets during the three and six months ended June 30, 2007 as compared to the corresponding periods in 2006.
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 six months ended June 30, 2007. Trading performance for the three and six months ended June 30, 2006 resulted in incentive fees of $0 and $1,237,713, respectively.
17
Table of ContentsItem 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.
The following table indicates the trading Value at Risk associated with the Master’s open positions by market category as of June 30, 2007 and the highest, lowest and average values during the three months ended June 30, 2007. All open position trading risk exposures of the Master have been included in calculating the figures set forth below. As of June 30, 2007, the Master’s total capitalization was $309,805,967.
June 30, 2007
(Unaudited)
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | Three months ended June 30, 2007 |
| Market Sector | | | Value at Risk | | | % of Total
Capitalization | | | High
Value at Risk | | | Low
Value at Risk | | | Average
Value at Risk* |
| Currencies: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| — OTC Contracts | | | | $ | 8,078,023 | | | | | | 2.61 | % | | | | $ | 11,367,341 | | | | | $ | 6,780,223 | | | | | $ | 8,267,143 | |
| Energy | | | | | 969,350 | | | | | | 0.31 | % | | | | | 969,350 | | | | | | 357,600 | | | | | | 735,117 | |
| Interest Rates U.S. | | | | | 4,120,200 | | | | | | 1.33 | % | | | | | 4,293,650 | | | | | | 53,207 | | | | | | 2,943,000 | |
| Interest Rates Non-U.S. | | | | | 7,860,338 | | | | | | 2.54 | % | | | | | 10,281,295 | | | | | | 3,366,038 | | | | | | 8,412,667 | |
| Metals: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| — Exchange Traded Contracts | | | | | 296,000 | | | | | | 0.10 | % | | | | | 390,000 | | | | | | 124,000 | | | | | | 299,333 | |
| — OTC Contracts | | | | | 1,143,021 | | | | | | 0.37 | % | | | | | 2,315,924 | | | | | | 854,405 | | | | | | 1,303,427 | |
| Indices | | | | | 5,742,025 | | | | | | 1.85 | % | | | | | 10,594,273 | | | | | | 5,347,848 | | | | | | 8,194,370 | |
| Total | | | | $ | 28,208,957 | | | | | | 9.11 | % | | | | | | | | | | | | | | | | | | |
| * Average of Month-end Values at Risk |
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Table of ContentsItem 4. Controls and Procedures
The Partnership’s disclosure controls and procedures are designed to ensure that information required to be disclosed under the Exchange Act is accumulated and communicated to management, including the Chief Executive Officer (CEO) and Chief Financial Officer (CFO) of the General Partner, to allow for timely decisions regarding required disclosure and appropriate SEC filings.
Management is responsible for ensuring that there is an adequate and effective process for establishing, maintaining and evaluating disclosure controls and procedures for the Partnership’s external disclosures.
The General Partner’s CEO and CFO have evaluated the effectiveness of the Partnership’s disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) as of June 30, 2007 and, based on that evaluation, the CEO and CFO have concluded that at that date the Partnership’s disclosure controls and procedures were effective.
The Partnership’s internal control over financial reporting is a process under the supervision of the General Partner’s CEO and CFO to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles. These controls include policies and procedures that:
| | |
| • | pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Partnership; |
| | |
| • | provide reasonable assurance that (i) transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and (ii) the Partnership’s receipts are handled and expenditures are made only pursuant to authorizations of the General Partner; and |
| | |
| • | provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Partnership’s assets that could have a material effect on the financial statements. |
There were no changes in the Partnership’s internal control over financial reporting during the fiscal quarter ended June 30, 2007 that materially affected, or are reasonably likely to materially affect, the Partnership’s internal control over financial reporting.
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Table of ContentsPART II. OTHER INFORMATION
Item 1. Legal Proceedings
The following information supplements and amends our discussion set forth under Part I, Item 3 ‘‘Legal Proceedings’’ in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006, as updated by our Quarterly Report on Form 10-Q for the quarter ended March 31, 2007.
Research
Customer Class Actions.
On May 3, 2007, the District Court remanded DISHER V. CITIGROUP GLOBAL MARKETS, INC., to Illinois state court. On June 13, 2007, Citigroup moved in state court to dismiss the action.
Mutual Funds
In May 2007, CGMI finalized its settlement agreement with the NYSE and the New Jersey Bureau of Securities on the matter related to its market-timing practices prior to September 2003.
IPO Securities Litigation
On May 18, 2007, the Second Circuit denied plaintiffs’ petition for rehearing en banc of the Second Circuit’s decision reversing the district court’s class certification.
IPO Antitrust Litigation
On June 18, 2007, the United States Supreme Court ruled that the securities law precludes application of the antitrust laws to the claims asserted by plaintiffs, effectively terminating the litigation.
Item 1A. Risk Factors
There are no material changes from the risk factors set forth under Part I, Item 1A. ‘‘Risk Factors’’ in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006 and under Part II, Item 1A, ‘‘Risk Factors’’ in the Partnership’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2007.
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Table of ContentsItem 2. Unregistered Sales of Equity Securities and Use of Proceeds
For the three months ended June 30, 2007, there were additional sales of 358.0111 Redeemable Units totaling $625,000. 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
Redeemable
Units Purchased* | | | (b) Average
Price Paid per
Redeemable Unit** | | | (c) Total Number
of Redeemable Units
Purchased as Part
of Publicly Announced
Plans or Programs | | | (d) Maximum Number
(or Approximate
Dollar Value) of
Redeemable Units that
May Yet Be
Purchased Under the
Plans or Programs |
April 1, 2007 -
April 30, 2007 | | | | | 1,760.2857 | | | | | $ | 1,746.38 | | | | | | N/A | | | | | | N/A | |
May 1, 2007 -
May 31, 2007 | | | | | 4,361.1743 | | | | | $ | 1,847.27 | | | | | | N/A | | | | | | N/A | |
June 1, 2007 -
June 30, 2007 | | | | | 2,967.3545 | | | | | $ | 1,931.02 | | | | | | N/A | | | | | | N/A | |
| | | | | | 9,088.8145 | | | | | $ | 1,841.56 | | | | | | | | | | | | | |
| * 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. |
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, 2006.
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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Table of ContentsSIGNATURES
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/ Jerry Pascucci |
| | | | Jerry Pascucci |
| | | | President and Director |
| Date: August 14, 2007 |
| By: | | | /s/ Jennifer Magro |
| | | | Jennifer Magro |
| | | | Chief Financial Officer and Director |
| Date: August 14, 2007 |
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