On May 18, 2015, the Commodity Futures Trading Commission (“CFTC”) published a final interpretation on forward contracts with embedded volumetric optionality (“Final EVO Interpretation”).1 In the Final EVO Interpretation—which the CFTC issued jointly with the Securities and Exchange Commission (“SEC”)—the CFTC adopted its November 2014 proposed revisions to the original seven-part volumetric optionality test, and provided greater clarity to market participants for determining whether a forward contract with embedded volumetric optionality would fall within the statutory definition of “swap” in section 1(a)(47) of the Commodity Exchange Act (“CEA”), as amended by section 721 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).
Background Under the statutory exclusion for nonfinancial commodity contracts in section 1a(47)(B)(ii) of the CEA, the sale of a nonfinancial commodity is excluded from the definition of “swap” (and, based on the CFTC’s interpretation, from the “future delivery” definition in pre-Dodd-Frank Act CFTC regulations) if the contract is intended to be physically settled (i.e., settled by physical delivery of the commodity).
In August 2012, the CFTC provided an interpretation as to when forward contacts “with embedded volumetric optionality” would fall within this “forward contract exclusion.”2 Forward contracts “with embedded volumetric optionality” are forward contracts for the sale of a commodity, but where one party has the right—but not the obligation—to increase or decrease the volume of the commodity intended to be physically settled or delivered under the forward contract. In the 2012 Products Release, the CFTC set forth a seven-part test for determining whether such contracts are excluded from the definition of “swap”:
- The embedded optionality does not undermine the overall nature of the agreement, contract, or transaction as a forward contract;
- The predominant feature of the agreement, contract, or transaction is actual delivery;
- The embedded optionality cannot be severed and marketed separately from the overall agreement, contract, or transaction in which it is embedded;
- The seller of a nonfinancial commodity underlying the agreement, contract, or transaction with embedded volumetric optionality intends, at the time it enters into the agreement, contract, or transaction, to deliver the underlying nonfinancial commodity if the optionality is exercised;
- The buyer of a nonfinancial commodity underlying the agreement, contract or transaction with embedded volumetric optionality intends, at the time it enters into the agreement, contract, or transaction, to take delivery of the underlying nonfinancial commodity if it exercises the embedded volumetric optionality;
- Both parties are commercial parties; and
- The 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.
The seventh element of the test created uncertainty among market participants—particularly regarding the meaning and application of the words “exercise or non-exercise” and “outside the control of the parties.” In response to invited comments from market participants submitted in October 2012 through November 2014 in various dockets and at various public roundtables, the CFTC proposed to revise the seven-part test in order to provide greater certainty to market participants.3
Final Interpretation The Final EVO Interpretation—which adopts wholesale the November 2014 proposal—includes the revisions to elements four, five, and seven, as indicated below:
4. The seller of a nonfinancial commodity underlying the agreement, contract, or transaction with embedded volumetric optionality intends, at the time it enters into the agreement, contract, or transaction, to deliver the underlying nonfinancial commodity if the embedded volumetric optionality is exercised;
5. The buyer of a nonfinancial commodity underlying the agreement, contract or transaction with embedded volumetric optionality intends, at the time it enters into the agreement, contract, or transaction, to take delivery of the underlying nonfinancial commodity if
it exercises the embedded volumetric optionality is exercised;
exercise or non-exercise of the embedded volumetric optionality is based primarily on intended, at the time that the parties enter into the agreement, contract, or transaction, to address physical factors, or regulatory requirements, that are outside the control of the parties and are influencing that reasonably influence demand for, or supply of, the nonfinancial commodity.
The minor changes to elements four and five are intended to clarify that the CFTC’s interpretation applies to embedded volumetric options or “optionality” in the form of both puts and calls. The CFTC also noted in the Final EVO Interpretation that elements four and five do not preclude bandwidth (or “swing”) contracts that provide for delivery of a commodity within a minimum and maximum range, and that embedded volumetric optionality may operate to increase and/or decrease the quantity delivered under the underlying forward contract.
The most significant changes, as expected, are to the seventh element. The CFTC modified the seventh element to remove the “exercise or non-exercise” and “outside the control of the parties” provisions, and reframed the seventh element so that the focus is on the intent of the party with the right to exercise the embedded volumetric optionality at the time of the contract initiation.
The CFTC also clarified the following with respect to the seventh element:
- Can rely on counterparty representations regarding intent. The intent of the party with the right to exercise the embedded volumetric optionality may be ascertained by the relevant facts and circumstances surrounding the contract, including the parties’ course of performance thereunder. However, parties to a contract may rely on counterparty’s representations (without conducting due diligence) regarding such counterparty’s “primary purpose” for embedding volumetric optionality in the contract, provided the relying party does not have information that would cause a reasonable person to question the accuracy of the representation.
- “Physical factors” construed broadly. The seventh element’s reference to “physical factors” should be construed broadly to include any fact or circumstance that could reasonably influence supply of or demand for the nonfinancial commodity, including environmental factors (e.g., weather, location), relevant operational considerations (e.g., availability of reliable transportation or technology), and broader social forces (e.g., changes in demographics or geopolitics). Moreover, the parties’ having some influence over such physical factors (e.g., the scheduling of plant maintenance or business expansion) is not inconsistent with the seventh element, provided that the embedded volumetric optionality is primarily intended at contract initiation to address potential variability in a party’s supply of or demand for the nonfinancial commodity.
- Optionality cannot be primarily intended to address price risk. The seventh element will not be satisfied if the embedded volumetric optionality is primarily intended, at contract initiation, to address concerns about price risk absent an applicable regulatory requirement (such as a utility receiving formal or informal guidance from its public utility commission or other governing body to obtain or provide the lowest price).
Implications for Market Participants The Final EVO Interpretation is a welcome development to the many commercial end-users who rely upon forward contracts with embedded volumetric optionality to help manage, hedge or mitigate the commercial risks arising from ongoing business operations. The original seven-part test created uncertainty among market participants, and it would seem that the Final EVO Interpretation provides a more workable analytical framework. To that end, although all of the CFTC Commissioners supported the Final EVO Interpretation, they did not all think it went far enough.
In a lengthy concurring statement, Commissioner Sharon Bowen expressed concern that the Final EVO Interpretation does not provide commercial parties sufficient clarity, and that it imposes unnecessary costs on manufacturing, energy, and agricultural companies that must comply with the CFTC’s regulations and interpretations regarding the definition of “swap” in section 1a(47) of the CEA. Commissioner Bowen urged broader relief and greater legal certainty for forward contracts with embedded volumetric optionality and other customary “physical commodity” contracts entered into by commercial entities.
It should also be noted that in the Final EVO Interpretation, the CFTC stated it would not require commercial parties to recharacterize existing contracts in light of its revised guidance on the seven-part test. Rather, commercial parties may choose to either rely on their good faith characterization of an existing contract based on the 2012 Products Release (e.g., as an excluded forward contract with embedded volumetric optionality or an exempt commodity trade option under the Trade Option Interim Final Rule), or recharacterize some or all of their existing contracts in accordance with the Final EVO Interpretation. The CFTC also pointed out that it has now proposed amendments to the Trade Option Interim Final Rule as well, in a continuing effort to provide clarity in implementing and interpreting section 721 of the Dodd-Frank Act and section 1a(47) of the CEA. For further discussion of the CFTC’s proposed trade option amendments, see our Alert on the topic here.
Dodd-Frank Rulemakings (and Legislative Efforts) Continue With the embedded volumetric optionality interpretation finalized, the focus now turns to other key Dodd-Frank rules on the horizon. Market participants will comment on the proposed amendments to the Trade Option Interim Final Rule, and are also awaiting final rules on position limits—the re-proposed final rule having been issued in December 2013 and the comment period reopened on several occasions. Market participants also await both CFTC and prudential regulators’ final rules on margin for non-cleared swaps—the re-proposed rules having been issued in September 2014. In addition, the CFTC is expected to either finalize or re-propose rules on regulatory capital requirements for non-cleared swaps held by swap dealers. Finally, the CFTC reauthorization act has again been introduced in the House of Representatives and it could address a broad range of revisions to current rules, including a number of proposed changes to the provisions of the Dodd-Frank Act and the CFTC’s regulatory processes and procedures that have been of most concern to commercial end-users.