On November 3, 2014, the Commodity Futures Trading Commission (“Commission” or “CFTC”) held an open meeting to consider and vote on three proposals, summarized below, to amend or interpret several existing rules. Each of the proposals was approved and is now subject to a period of public comment prior to any subsequent final action by the Commission. Proposals; Comment Periods Residual Interest Posting Deadline: The Commission is proposing to amend CFTC Rule 1.22(a) to provide that the deadline for posting residual interest (the “Residual Interest Deadline”) will remain 6:00 p.m. Eastern Time, unless further revised through a subsequent rulemaking.1
The Commission voted unanimously in favor of this proposal, comments on which are due on or before January 13, 2015. Relief from Certain Recordkeeping Requirements: The Commission is proposing to amend the recordkeeping requirements of Rule 1.35(a) to (i) provide that all records required to be maintained under the Rule be searchable, and (ii) clarify that such records, though not including records of oral and written communications leading to the execution of a transaction in a commodity interest and related cash or forward transactions, must be kept in a form and manner that allows for identification of a particular transaction. The proposal would also exclude commodity trading advisors (“CTAs”) that are members of a designated contract market (“DCM”) or a swap execution facility (“SEF”) from the oral recordkeeping requirement, and would exclude members of DCMs or SEFs that are not registered or required to register with the Commission (“Unregistered Members”) from the requirement to retain text messages, to retain records in a searchable format, and to maintain records in a particular form and manner that allows for
1 See CFTC, “Residual Interest Deadline for Futures Commission Merchants”, 79 Fed. Reg. 68148 (November 14, 2014).Fried Frank Client Memorandum 2 identification of a particular transaction.2 The Commission voted three to one in favor of this proposal, with Commissioner Giancarlo dissenting. Comments on this proposal are due on or before January 13, 2015. Clarification of Treatment of Forwards with Embedded Volumetric Optionality: The Commission and the Securities and Exchange Commission (“SEC”) are jointly proposing3 a clarification of the Commission’s interpretation regarding whether forward contracts with “embedded volumetric optionality” (“EVO”) qualify for the forward contract exclusion from the “swap” and “future delivery” definitions in the Commodity Exchange Act (“CEA”). 4 The Commission voted unanimously in favor of this proposal, comments on which are due on or before December 22, 2014. Residual Interest Posting Deadline Generally, CFTC Rule 1.22 prohibits a futures commission merchant (“FCM”) from using the funds of one futures customer for the account of any person other than such futures customer. It also requires each FCM to compute the total aggregate amount that its customer accounts are undermargined and to make up any shortfalls with its own funds (the “Residual Interest”) by the specified Residual Interest Deadline.5
Last year, the Commission established a phased-in schedule for complying with the Residual Interest requirement, with an initial Residual Interest Deadline of 6:00 p.m. Eastern Time on the date of the settlement referenced in Rule 1.22(c)(2)(i) (i.e., the following business day, or “T+1”) (the “Settlement Date”), beginning November 14, 2014.6 In addition, last year the Commission directed the staff by May 16, 2016 to complete and publish for public comment a report (the “Report”) addressing the practicability, feasibility, costs and benefits, and potential requirements of moving up the Residual Interest Deadline to the time of settlement or to some other time of day. The Commission further directed the staff to solicit public comment and conduct a public roundtable regarding specific issues to be covered by the Report. Within nine months after publication of the Report, the Commission may terminate the phase-in period, or determine that it is necessary or appropriate in the public interest to propose through a separate rulemaking a different Residual Interest Deadline. Absent further CFTC action, the phased-in compliance period would have terminated December 31, 2018 and upon such termination the Residual Interest Deadline would have automatically moved to the time of settlement on the Settlement Date, i.e., 9:00 a.m. Eastern Time.
2 See CFTC, “Records of Commodity Interest and Related Cash or Forward Transactions”, 79 Fed. Reg. 68140 (November 14, 2014). 3 Section 712(d)(4) of The Dodd-Frank Wall Street Reform and Consumer Protection Act requires that any interpretation issued by either agency under the relevant title be issued jointly by the CFTC and SEC. Nevertheless, the guidance would be provided solely by the CFTC and would not apply to securities transactions. 4 See CFTC/SEC, “Forward Contracts With Embedded Volumetric Optionality”, 79 Fed. Reg. 69073 (November 20, 2014). 5 The Residual Interest Deadline is defined in CFTC Rule 1.22(c)(5). 6 See CFTC, “Enhancing Protections Afforded Customers and Customer Funds Held by Futures Commission Merchants and Derivatives Clearing Organizations”, 78 Fed. Reg. 68506 (November 14, 2013).Fried Frank Client Memorandum 3 Under the current proposal, the Residual Interest Deadline would remain 6:00 p.m. Eastern Time, unless further revised through a subsequent CFTC rulemaking. Specifically, this proposal would remove both the scheduled December 31, 2018 automatic termination of the phased-in compliance period and the ensuing movement of the Residual Interest Deadline up to the time of settlement on the Settlement Date in accordance with CFTC Rule 1.22(c)(5)(iii)(C). The Commission is also proposing to revise Rule 1.22 to make clear that any subsequent revision to the Residual Interest Deadline would have to be effected through a separate rulemaking. The proposed change therefore does not alter the current requirement that, beginning November 14, 2014, all FCMs must maintain the requisite Residual Interest in customer accounts by no later than 6:00 p.m. Eastern Time on the Settlement Date, i.e., T+1. Certain Relief from Recordkeeping Requirements Rule 1.35(a) sets forth specific recordkeeping requirements for FCMs, retail foreign exchange dealers, introducing brokers, and members of DCMs or SEFs. On December 21, 2012, the Commission published a final rulemaking (the “Final Rule)7 requiring each such class of market participant to keep full, complete and systematic records of all written and oral communications leading to the execution of transactions relating to its business of dealing in commodity interests and related cash or forward transactions. This requirement extends to communications made by telephone and voicemail, as well as facsimile, instant messaging, chat rooms, electronic mail, mobile device, text message and other digital and electronic media. This requirement is limited to transactions in a commodity interest and includes a person that is registered or required to register with the CFTC as a CTA and that is a member of a DCM or a SEF. The Final Rule also mandates that such records be kept in a form and manner identifiable and searchable by transaction. Subsequent to adoption of the Final Rule, the Commission and its staff took a series of actions in response to comments from market participants, including the issuance of CFTC Staff Letter No. 14-60 (April 25, 2014), which grants CTAs that are members of SEFs or DCMs no-action relief from the requirement to record oral communications in connection with the execution of swaps (this relief, which expires December 31, 2014, is anticipated to be extended by the CFTC staff in some form until final action is taken on the current rulemaking proceeding). Also, the staff issued CFTC Staff Letter No. 14-72, which grants Unregistered Members no-action relief from the requirements under Rule 1.35(a) to (i) retain text messages and (ii) store required records in a form and manner identifiable and searchable by transaction. The relief provided for Unregistered Members will remain effective until the effective date of any final CFTC action.8 In view of the concerns, presented by market participants affected by the Final Rule, the Commission is proposing the following amendments to Rule 1.35(a): An amendment to clarify that while all required records would have to be searchable and “identifiable by transaction,” the records need not be “searchable by transaction.”
7 See CFTC, “Adaptation of Regulations To Incorporate Swaps—Records of Transactions”, 77 Fed. Reg. 75523 (December 21, 2012). 8 See also CFTC Staff Letter No. 13-77 (December 20, 2013); CFTC Staff Letter No. 14-33 (March 21, 2014). Fried Frank Client Memorandum 4 As an exception to the current Rule 1.35(a) requirement that records be “identifiable by transaction”, an amendment of Rule 1.35(a) to clarify that records of oral and written communications provided or received concerning quotes, solicitations, bids, offers, instructions, trading and prices that lead to the execution of a transaction in a commodity interest and related cash or forward transactions would not be required to be kept in a form and manner that allows for identification of a particular transaction. Thus, a market participant would not be required to link or otherwise identify to a particular transaction a record of a communication that leads to the execution of a transaction. However, these records would still have to be searchable. The proposal would codify the no-action relief granted in Letter No. 14-72, providing that Unregistered Members of DCMs or SEFs would be excluded from the Rule 1.35(a) requirements to retain text messages and keep records in a searchable format and in a form and manner that allows for identification of a particular transaction. All CTAs that are members of a DCM or SEF would be excluded from the current Rule 1.35(a) requirement to record all oral communications that lead to the execution of a transaction in a commodity interest. The CFTC understands that many CTAs have discretionary trading authority over their clients’ accounts and, therefore, those CTAs do not have routine telephone conversations with clients that lead to the execution of an order on a DCM or SEF. However, the CFTC is not proposing to exclude CTAs that are members of a DCM or SEF from the written recordkeeping requirements of Rule 1.35(a), because certain CTAs may receive orders from their clients that they then execute on behalf of those clients on a non-discretionary basis, and CTAs may also receive instructions changing or limiting their discretionary authority. Clarification of Treatment of Forwards with Embedded Volumetric Optionality In Further Definition of “Swap,” Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping (the “Products Release”),9 the Commission provided an interpretation of the forward contract exclusion that addresses variations in delivery amount (i.e., forwards that contain EVO).10 Specifically, the Commission articulated a Seven Factor Test for identifying when an agreement, contract or transaction would fall within the forward contract exclusion from the “swap” and “future delivery” definitions in the CEA despite containing EVO.11 As previously provided, the seventh factor states that an agreement, contract or transaction falls within the forward exclusion from the swap and future delivery definitions, notwithstanding that it contains EVO, when “[t]he exercise or non-exercise of the embedded volumetric optionality is based primarily on physical factors, or regulatory requirements, that are outside the control of the parties and are influencing demand for, or supply of, the nonfinancial commodity.”12 Two primary issues with respect to the seventh factor have caused ambiguities and difficulties for end users and market participants. First, the phrase “outside the control of the parties” has created problems
9 See 77 Fed. Reg. 48207 (August 13, 2012). 10 See Products Release at 48238-42. 11 Id. at 48238-42 and n.335. 12 Id. at 48238-42 (citations omitted).Fried Frank Client Memorandum 5 during contract negotiations, as counterparties often disagree about the degree of control they have over factors influencing their demand for or supply of the nonfinancial commodity. Additionally, parties have been uncertain about how to characterize contracts at the time of execution, as they often do not know until the time of exercise the exact reasons why optionality will be exercised. In response, the proposed interpretation would clarify further the seventh factor. As proposed to be amended, the seventh factor would read: “7. The embedded volumetric optionality is primarily intended, at the time that the parties enter into the agreement, contract, or transaction, to address physical factors or regulatory requirements that reasonably influence demand for, or supply of, the nonfinancial commodity.” 13 Thus, this proposal first removes reference to the “exercise or non-exercise” of the EVO, thereby clarifying that the focus of the seventh factor is intent with respect to the EVO at the time of contract initiation. The Commission would further clarify that commercial parties may rely on counterparty representations with respect to the intended purpose for embedding volumetric optionality in a contract, provided the parties are unaware, and should not reasonably have been aware, of facts indicating a contrary purpose. The proposal also removes reference to physical factors or regulatory requirements being “outside the control of the parties.” By removing this language, the Commission intends to clarify that parties may have some influence over factors affecting their demand for or supply of the nonfinancial commodity, provided that the EVO is included in the contract at initiation primarily to address potential variability in a party’s supply of or demand for the nonfinancial commodity. Finally, the Commission is also proposing to clarify that the phrase “physical factors” should be construed broadly to include any fact or circumstance that could reasonably influence supply of or demand for the nonfinancial commodity under the contract. Such facts and circumstances could include not only environmental factors, such as weather or location, but relevant “operational considerations” (e.g., the availability of reliable transportation or technology) and broader social forces such as changes in demographics or geopolitics. In contrast, concerns that are primarily about price risk (e.g., expectations that the cash market price will increase or decrease) would not satisfy the seventh factor absent an applicable regulatory requirement to obtain or provide the lowest price (e.g., the buyer is an energy company regulated on a cost-of-service basis). Given that the Commission has just proposed these amendments for public comment, we cannot be sure when these amendments will be finalized, and if so, in what form. We will continue to monitor and report on developments on the three proposed amendments discussed above. * * *
13 See n.4.supra.Fried Frank Client Memorandum New York Washington, DC London Paris Frankfurt Hong Kong Shanghai friedfrank.com 6 Authors: Robert M. McLaughlin David S. Mitchell William J. Breslin Janet C. Choi Special thanks to Harry R. Kaplan, Corporate Law Clerk, for his valuable assistance in the research and drafting of this client memorandum. This memorandum is not intended to provide legal advice, and no legal or business decision should be based on its contents. If you have any questions about the contents of this memorandum, please call your regular Fried Frank contact or an attorney listed below: Contacts: New York Robert M. McLaughlin +1.212.859.8963 firstname.lastname@example.org David S. Mitchell +1.212.859.8292 email@example.com Washington, D.C. Daniel A. Mullen +1.202.639.7180 firstname.lastname@example.org