The CFTC has published an important proposed clarification to its seven element test regarding forward contracts with embedded volumetric optionality (EVO). The proposed interpretation provides that a contract for deferred delivery of a physical commodity (i.e., a forward contract) that contains EVO will fall within the forward contract exclusion, and thus not be regulated as an option (despite the embedded “optionality”) under the CFTC’s swaps or futures regulatory regimes, when:
- 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.
Proposed Fix to the Problematic Seventh Element
The proposed test would replace the currently effective seven-element test, which was issued in the CFTC’s 2012 rulemaking that set forth a definition of the term “swap.” The seventh element in the current test has been criticized by numerous industry groups and market participants (particularly in the energy industry) as unworkable–largely because of its explicit focus on the “exercise or non-exercise” of the EVO in a contract. Many consider this to require analysis of contracting parties’ intent at the time of exercise or non-exercise of the EVO (as opposed to the time of execution of the underlying contract), a task that is considered fraught with uncertainty and unpredictability—to the point that many consider reliance on counterparty representations to be untenable.
The proposed revision to the seventh element seems to largely fix this issue. The CFTC is proposing to remove the reference to the “exercise or non-exercise” of the EVO. By removing this language, the CFTC “intends to clarify that the focus of the seventh element is intent with respect to the embedded volumetric optionality at the time of contract initiation.” Thus, as long as the intended purpose for including EVO at the time of contract execution is to address physical factors or regulatory requirements influencing the demand for or supply of the commodity, the ultimate reason for exercise or non-exercise of the EVO (even if it ultimately turns out to be price) should be irrelevant. The CFTC also further advises that commercial parties “may rely on counterparty representations with respect to the intended purpose for embedding volumetric optionality in the contract, provided they are unaware, and should not reasonably have been aware, of facts indicating a contrary purpose.”
The proposed interpretation clarifies that parties having some influence over factors affecting their demand for or supply of the nonfinancial commodity (e.g., the scheduling of plant maintenance, plans for business expansion) should not be considered inconsistent with the seventh element, 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.” It also clarifies that the term ‘‘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—including 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. Concerns that are primarily about price risk (e.g., that the cash market price will increase or decrease) at the time of contract initiation will not satisfy the seventh element, but the CFTC clarified that even such price risk concerns at initiation may satisfy the test if they are motivated by an applicable regulatory requirement to obtain or provide the lowest price (e.g., if the buyer is an energy company regulated on a cost-of-service basis).
To many industry groups and market participants, the proposed clarification, by narrowing the sweep of CFTC swap regulation to contracts that are more “derivative” or “speculative” in nature, restores the scope of CFTC swap/option regulation to what they believe Congress envisioned in passing the Dodd-Frank Act. To be sure, the new test seems likely to exclude many widely used contracts containing EVO that have generally been viewed as run-of-the mill forward contracts that merely provide commercially reasonable flexibility with respect to delivery volume in order to address uncertain supply and demand conditions. As such, the proposed interpretation is an extremely welcome development to market participants in physical commodity-based industries.
Proposed Fixes to Fourth and Fifth Elements (Extension to “Puts”)
The CFTC also revised the fourth and fifth elements in a manner that appropriately addresses “put” optionality, as opposed to just “call” optionality.
Comments on the proposed interpretation must be received by the CFTC on or before December 22, 2014.