On November 13, 2014, the Commodity Futures Trading Commission (the CFTC) and the Securities and Exchange Commission (the SEC) proposed a clarification (the Proposed Clarification) of the CFTC’s interpretation regarding forward contracts with embedded volumetric optionality, building off the 2012 round of rulemaking that defined “swap” for the purposes of the Commodity Exchange Act (the 2012 Interpretation). If adopted as a final interpretation, the Proposed Clarification should give more certainty to market participants who enter into forward contracts allowing for adjustments in delivery amount regarding whether their contracts would be regulated as swaps under the Dodd-Frank Act. The Proposed Clarification may affect contracts entered into by various types of market participants, including energy companies, manufacturers, and commodity trading companies. Comments regarding the Proposed Clarification must be submitted to the CFTC on or before December 22, 2014. While the Dodd-Frank Act requires the Proposed Clarification to be a joint release by the CFTC and the SEC, this alert will refer to both the 2012 Interpretation and the Proposed Clarification as the work of the CFTC, which is the agency tasked with regulating commodity forwards.
By way of background, forward contracts, which involve the sale of a nonfinancial commodity or security for deferred shipment or delivery with the intention of physical settlement, have been excluded from the definition of “swap” pursuant to the so-called forward contract exclusion.” However, commercial market participants are often unable to accurately predict the precise volume of required delivery at the time the contract is initiated. This may be due to a variety of factors affecting production volumes and/or delivery needs, including weather, transportation capacity, and regulatory requirements. Thus, buyers and sellers of nonfinancial commodities may choose to enter into contracts that allow for the volume of delivery to be adjusted following entry into the contract. Such agreements are known as forward contracts with embedded volumetric optionality.
In 2012, the CFTC interpreted forward contracts containing an embedded commodity option or options as nonfinancial commodity forward contracts, and as such, excluded from the definition of “swap.” In issuing the 2012 Interpretation, the CFTC adopted a seven-part test for determining whether the embedded volumetric optionality is of a type that would make the agreement fall within the forward contract exclusion. The seventh factor of the seven-part test was that “[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.” Accordingly, for purposes of the seventh factor, the decision regarding delivery volumes is the main focus of inquiry. Many market participants found the seventh factor difficult to evaluate and apply in practice, due to the need to ascertain the motive for the delivery decision and the uncertainty regarding the extent to which physical factors are outside the parties’ control.
II. Proposed Clarification
The Proposed Clarification reformulates the seven-factor test for determining whether a forward contract with embedded volumetric optionality is an excluded forward contract to read as follows:
- 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 embedded volumetric 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 the embedded volumetric optionality is exercised;
- Both parties are commercial parties; and
- 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.
A contract that fails under one or more of the seven factors may still be exempt from regulation under the Dodd-Frank Act by qualifying for an exception to the requirement that commodity options must be regulated as swaps, either as a commodity option embedded in a forward contract, a volumetric commodity option embedded in a forward contract, or a trade option. In the Proposed Clarification, the CFTC is not seeking to disturb its existing rules regarding those types of options.
The first, second, third, and sixth factors have not generated much uncertainty and are the same in the Proposed Clarification as they were in the 2012 Interpretation. The fifth prong has been slightly reworded to be consistent with the fourth prong, so that the last clause in each now reads in the passive voice, thus clarifying that the interpretation applies regardless of whether the embedded volumetric optionality is in the form of a put or a call. The more impactful changes appear in the seventh prong, which under the Proposed Clarification focuses on the intention of the parties at the time they enter into the agreement rather than at the time one of the parties exercises the embedded optionality, as is the case in the 2012 Interpretation. The CFTC now states that the 2012 Interpretation has led to problems during contract negotiations, as some parties have felt the pressure to specify the precise factors that could result in the exercise or non-exercise of optionality. The CFTC further advises in the Proposed Clarification that parties may rely, in the absence of any knowledge to the contrary, on their counterparties’ representations in connection with the intended purpose for including optionality in the forward contract.
By proposing to move the regulatory emphasis to the initial contract, instead of follow-up adjustments in the volume of the delivery obligation, the CFTC may be seeking to create a consistent approach to evaluating the applicability of the Dodd-Frank Act to different types of forward contracts. For instance, in determining whether book-out transactions fall under the scope of the Dodd-Frank Act, the question does not concern the intention of the parties at the time they decide to book out the transaction but whether the original transaction creates a binding obligation to make or take delivery without providing any right to offset, cancel, or settle on a payment-of-differences basis. Similarly, in the Proposed Clarification, the CFTC states in a footnote that commercial parties may consider a variety of factors, including price, in deciding whether to exercise the embedded volumetric optionality, so long as the intended purpose for including the optionality in the contract is consistent with the seventh prong. Thus, the Proposed Clarification may give contract participants more certainty that by including the proper representations and acknowledgments at the time the contract is drafted, they are entering into a commodity forward transaction that is exempt from regulation under the Dodd-Frank Act.
In addition, the CFTC is proposing to revise the seventh prong by removing references to physical factors and regulatory requirements being outside the control of the parties. The CFTC now acknowledges that this language is problematic because parties often disagree regarding their degree of control over various factors affecting supply and demand for a nonfinancial commodity. For instance, parties have some control over scheduling plant maintenance and expanding their businesses. According to the proposed interpretation, for the purposes of the forward contract exemption, some degree of influence over factors affecting supply or demand is allowed so long as the parties’ intent at the time of contract initiation is to address potential variability for demand or supply of the nonfinancial commodity.
The CFTC further proposes to clarify that “physical factors” should be interpreted broadly so as to include any fact or circumstance that “could reasonably influence” supply of or demand for the nonfinancial commodity, which would include environmental factors, operational considerations, and broader social forces, but would exclude concerns primarily about price risk, in the absence of a regulatory requirement in connection with obtaining or providing the lowest price. Unless further clarified in the final clarification, there may be some lingering uncertainty regarding the scope of this factor, as the CFTC in the Proposed Clarification uses the phrase “reasonably influence,” as stated in the seven factors listed above, but later uses the potentially broader phrase “could reasonably influence,” in either case a departure from the “are influencing” phrase in the 2012 Interpretation.
As an example, suppose that Buyer and Supplier, both commercial participants, enter into a contract on December 1, 2014 for Supplier to provide 10,000 barrels of crude oil at $90 per barrel on February 1, 2015. The contract states that in the event of warmer-than-average temperatures in the northern U.S. in January 2015, Buyer has the option to decrease the delivery volume to 5,000 barrels, and the parties represent in the contract that the primary intent of this optionality is to address weather. Suppose further that while temperatures in January 2015 end up being slightly warmer than average, causing a modest downward effect on the demand for energy, the market price of crude drops to $70 per barrel as of February 1, 2015, and Buyer decides to perform routine maintenance at its facilities, decreasing Buyer’s intake capacity. Accordingly, Buyer proceeds to exercise its option to decrease the delivery volume, with this decision based primarily on price movement and capacity, not weather.
Under the 2012 Interpretation, this contract is unlikely to satisfy the seventh factor of the seven-factor test, as Buyer’s exercise of the embedded volumetric optionality is not based primarily on physical factors or regulatory requirements. Under the Proposed Clarification, however, the contract is more likely to qualify under the seventh factor, since the focus is on the parties’ intention at the time the contract was entered into and not the time the option was exercised.