As a general matter, commodity swaps and options on commodities, whether or not physically settled, are subject to regulation under the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"). This is because the definition of "swap" contained in the Commodities Exchange Act (the "CEA") includes any agreement commonly known as an energy swap, an emissions swap or a commodity swap and any option on any such agreement. In addition, the term "swap" includes an "option of any kind that is for the purchase or sale, based on the value of 1 or more commodities." However, there are exclusions from the definition of "swap," including an exclusion for any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled (the "Forward Contract Exclusion").
On July 10, 2012, the Commodities Futures Trading Commission (the CFTC) and the Securities Exchange Commission (the SEC) issued a joint final rule and interpretations effective October 12, 2012 (the "Joint Final Rule") under Dodd-Frank, further defining the term "swap" and interpreting the Forward Contract Exclusion. This alert discusses the Forward Contract Exclusion and its implications.
In addition, on April 27, 2012, the CFTC published an interim final rule providing for a trade option exemption (the "Trade Option Exemption"), which exempts certain commodity options from many provisions of the Dodd-Frank regulatory regime. Although the compliance date of the Trade Option Exemption is also October 12, 2012, commodity option market participants need not comply with any rule or regulation applicable to a commodity option until that rule or regulation is applicable to swaps generally. This alert also discusses the Trade Option Exemption and its implications.1
Finally, on August 15, 2012, the CFTC issued a no-action letter providing that market participants may temporarily rely on the Trade Option Exemption for relief from all provisions of Dodd-Frank applicable to swaps, other than anti-fraud, anti-manipulation and position limits.
- The Forward Contract Exclusion
The Forward Contract Exclusion from the definition of swap requires that:
- the commodity be a nonfinancial commodity
- the transaction be a sale for deferred shipment or delivery, and
- the parties intend to physically settle the sale.
Scope of the Definition of "Nonfinancial Commodity"
Under the Joint Final Rule, the CFTC gives an interpretation of nonfinancial commodities as commodities that are exempt commodities or agricultural commodities that can be physically delivered. Exempt commodities are in turn defined as commodities that are not excluded commodities2 or agricultural commodities. Because excluded commodities are financial in nature, the Forward Contract Exemption is available for all commodities other than those that are financial in nature.
In the Joint Final Rule, the CFTC also interprets the Forward Contract Exclusion as available to intangible commodities, if such intangible commodities can be physically delivered. In the case of intangible commodities, the CFTC interprets physical delivery as an ability to convey ownership of the commodity and that the commodity can be consumed. The CFTC notes in particular that an environmental commodity, such as an emissions allowance, is eligible for the Forward Contract Exclusion because it can be physically delivered and consumed (e.g., by emitting the relevant amount of pollutants).
Sale for "Deferred Shipment or Delivery"
Before the enactment of Dodd-Frank, the CFTC had occasion to interpret when a sale of a cash commodity for deferred shipment or delivery was not within its jurisdiction as a futures contract. In the Joint Final Rule, the CFTC states that it will interpret the forward exclusion for nonfinancial commodities from the definition of swap consistently with its historical interpretation of the existing forward exclusion with respect to futures contracts.
The historical premise of the forward exclusion is that the regulatory scheme should not apply to private "commercial merchandizing transactions" that create enforceable obligations to deliver, but in which delivery is deferred due to commercial convenience or necessity. The forward exclusion is designed to exempt transactions where the intent is to transfer ownership of the commodity and not just its price risk.
Determining the Intent to Physically Settle
In determining whether a transaction is a commercial mechanizing transaction, the CFTC has historically applied a "facts and circumstances" test to determine the parties’ intent regarding delivery.
Brent Interpretation Safe Harbor Applicable
In the Joint Final Rule, the CFTC is providing a final interpretation that the principles underlying the safe harbor provided by the "Brent Interpretation" regarding "book-outs" apply in the swap context. Under the facts of the Brent Interpretation, multiple parties entered into a chain of contracts under which they would be required to make or take delivery of crude oil, without the right to offset, cancel or settle on a payment-of-differences basis. A seller under a contract gives notice to a buyer who in turn must give timely notice to its buyer until notice is given to the buyer who elects to take delivery or has insufficient time to pass on the notice. Title passes down the chain: each seller is responsible for delivery of the cargo and each purchaser is responsible for its negotiated purchase price. If the parties determine that they have offsetting positions, however, in lieu of effecting deliveries, they frequently negotiate payment-of-differences pursuant to a separate, individually negotiated agreement referred to as a "book-out." The Brent Interpretation is only available between "commercial participants in connection with their business."
In the Joint Final Rule, the CFTC provides interpretative guidance that commercial market participants that regularly make or take delivery of the referenced nonfinancial commodity in the ordinary course of their business may qualify for the Forward Contract Exclusion, notwithstanding that they enter into "book-out" transactions within the meaning of the Brent Interpretation. Intent to make or take delivery is to be inferred from the fact that the parties to the contract do, in fact, regularly make or take delivery of the referenced commodity in the ordinary course of their business. By contrast, the CFTC rejects the application of the Brent Interpretation to financial players who make or take delivery of the commodity in connection with their business. The CFTC limits its interpretation to commercial participants, and interprets commercial in this context to mean "related to the business of a producer, processor, fabricator, refiner or merchandiser."
Certain Energy Exemption Principles Preserved
Because the CFTC has extended the Brent Interpretation to nonfinancial commodities, it has determined to withdraw the Energy Exemption,3 which, among other things, extended the Brent Interpretation to energy commodities other than oil. However, the Energy Exemption was in several respects broader than the Brent Interpretation. As a result, the CFTC expressly clarifies the acceptability of certain principles set forth in the Energy Exemption. The CFTC clarifies as consistent with the Brent Interpretation bilateral netting arrangements, whether entered into at time of the original energy contract or subsequently, whereby parties net delivery of the same commodity to be delivered at the same location and during the same delivery period. However, the CFTC adds criteria to the principles set forth in the Energy Exemption by requiring that the parties when entering into the transaction have a bona fide intent to make or take delivery and that the offset be unintentional.
In addition, a failure to deliver as a result of the exercise of a "bona fide termination right" will not render the delivery obligation non-binding. However, the bona fide termination right must be unexpected by the parties at the time the contract is entered into.
Finally, the CFTC confirms as generally acceptable certain physical delivery options described in the Energy Exemption: (1) "grade exchanges" whereby one quality, grade or product type is exchanged for another, and (2) passage of title and acceptance of a commodity, if the buyer does not lift the cargo but instead passes title to a subsequent purchaser in a chain.
Commodity Options Embedded in Financial Contracts
As stated above, the CFTC states that it will interpret the forward exclusion from the definition of swap in the same manner as its historical interpretation of the existing forward exclusion with respect to futures contracts. Using such historical principles, the CFTC provides a final interpretation that a forward contract that contains an embedded commodity option or options will be an excluded nonfinancial commodity forward (and not a swap) if the embedded option(s):
- may be used to adjust the forward contract price, but do not undermine the overall nature of the contract as a forward contract
- do not target the delivery term, so that the predominant feature of the contract is actual delivery, and
- cannot be severed and marketed separately from the overall forward contract in which they are embedded.
For example, the CFTC states that contracts with volumetric optionality may satisfy the Forward Contract Exclusion, and gives a list of seven necessary factors, including that the exercise or non-exercise of embedded volumetric optionality is based primarily on physical factors or regulatory requirements that are outside of the control of the parties. Similarly, as evaluated on a facts and circumstances basis, full requirements contracts, capacity contracts, transmission (or transportation) services agreements, tolling agreements and peaking supply contracts may satisfy the "forwards with embedded volumetric option" interpretation, and hence the Forward Contract Exclusion.
The CFTC provides an interpretation that it does not consider evergreen or extension terms as options on the delivery terms. By stating as a condition that the embedded option may not "target the delivery term," the CFTC intends that the embedded option not affect the delivery amount so long as delivery eventually occurs.
Finally, the CFTC provides an interpretation of certain physical supply and consumption agreements with option-like features, as not options (and therefore not swaps). In response to commenters' description of certain physical tolling agreements as lease-like, the CFTC provides an interpretation that a contract will not be an option if: (1) the subject of the contract is the use of the facility, and not the purchase or sale of the commodity associated with the facility, (2) the contract grants the buyer the exclusive use of the specified facility or relevant part thereof, and (3) the payment is a payment for use rather than a payment for an option for use. However, if the exercise of the right to use the facility entails fees incremental to the original fees, the agreement will be deemed to be an option.
- The Trade Option Exemption
As stated above, the definition of swap includes "[an] option of any kind that is for the purchase or sale, or based on the value, of 1 or more ... commodities." This definition does not exclude physically settled options. However, pursuant to the Trade Option Exception, issued as an interim final rule, qualifying option transactions will be exempt from compliance with certain provisions of Dodd-Frank applicable to swaps.
The provisions of the Trade Option Exemption are that:
- the offeror must be (a) an eligible contract participant, or (b) a producer, processor, a commercial user of, or a merchant with respect to the commodity or products or by-products thereof, and such offeror is offering the commodity option solely for purposes related to its business
- the offeror must have a reasonable basis to believe that the offeree is a producer, processor, a commercial user of or a merchant with respect to the commodity or products or by-products thereof, and such offeree is offered or entering into the commodity option solely for purposes related to its business as such
- the offeree must satisfy the offeree criteria referred to in number 2 above, and
- the commodity option must be intended to be physically settled, so that if exercised, the option would result in the sale of an exempt or agricultural commodity for immediate or deferred shipment or delivery. The intent to physically settle is to be interpreted in accordance with the Joint Final Rule.
The intent of the Trade Option Exemption is to provide an exemption from many of the rules otherwise applicable to swaps under the Dodd-Frank regime. However, the recordkeeping and reporting requirements are retained to maintain transparency. An annual notice filing alternative (as an alternative to swap-by-swap real time reporting) is provided if neither counterparty to a trade option otherwise submits reports to a swap data repository as a result of its swap trading activities. In addition, the capital and margin requirements on swap dealers and major swap participants continue to apply, which govern initial margin and margin threshold requirements with respect to counterparties to swap dealers and major swap participants. Finally, large trader reporting requirements, position limits, risk management procedures applicable to swap dealers, and anti-fraud and anti-manipulation rules continue to apply.
- No-Action Letter and Possible Amendments
In the Joint Final Rule, the CFTC states that its interpretation regarding forwards with volumetric optionality may be relied upon by market participants, but that it nevertheless invites public comment on all aspects of the interpretation. Similarly, in the Trade Option Exemption, the CFTC invites comments in order to assess whether or not to amend its terms.
In the Joint Final Rule, the CFTC states that it will be issuing no-action relief with respect to compliance with the regulatory provisions of Dodd-Frank for market participants that otherwise comply with the provisions of the Trade Option Exemption. On August 15, 2012, the CFTC issued such a no-action letter stating the intent that market participants acting in compliance with the terms of the terms of Trade Option Exemption will have until the earlier of December 31, 2012, and the effective date of any final action taken by the CFTC, not to be subject to the Dodd-Frank regulatory regime, except for the anti-fraud and anti-manipulation rules and position limits. According to the Joint Final Rule, the purpose of this relief is to afford the CFTC an opportunity to review and evaluate the comments received on both the interpretation regarding forwards with volumetric optionality and the Trade Option Exemption, to determine if any changes are appropriate.
Commodity swaps and options on commodities (whether or not physically settled) are swaps. The CFTC has provided relief from the Dodd-Frank regulatory regime for agreements satisfying the Forward Contract Exclusion, which it determines are not swaps, and agreements satisfying the Trade Option Exemption, which although they are swaps are exempt from many of the requirements of the regulatory regime. However, the exclusion and exemption are conditioned on adherence to requirements, including the nature of the parties, and the intent to physically settle, which intent will be determined on a facts and circumstances basis.