The Commodity Futures Trading Commission (“CFTC”) has finalized two rules to authorize swaps (other than options) in agricultural commodities which will (i) correct existing inconsistencies, bring the regulation of agricultural swaps in line with the regulation of all other swaps under the CFTC’s jurisdiction1, and clarify that agricultural swaps may be listed or traded on swap execution facilities or designated contract markets, and (ii) provide a definition for regulatory purposes of the term “Agricultural Commodity.” The changes effected through these final rules should benefit participants in the agricultural swaps market by providing legal certainty and simplifying counterparty and regulatory diligence procedures.
As a result of amendments to the Commodity Exchange Act (the “CEA”) made pursuant to the Dodd-Frank Act:
- with limited exceptions, swaps and options in an “Agricultural Commodity” (to be defined by the CFTC) are prohibited unless entered into pursuant to a rule, regulation or order of the CFTC adopted pursuant to its exemptive authority under Section 4(c) of the CEA2, and
- a swap execution facility (“SEF”)3 may not list for trading or confirm the execution of any swap or option in an Agricultural Commodity except pursuant to a rule or regulation of the CFTC allowing the swap under such terms and conditions as the CFTC shall prescribe4.
In order to address these concerns and to rationalize the treatment of agricultural swaps under the post-Dodd-Frank Act regulatory framework, the CFTC recently promulgated final rules to authorize swaps in Agricultural Commodities (the “Agricultural Swaps Final Rules”) and to establish a definition of the term Agricultural Commodity (which had been previously undefined) for such purpose. The CFTC had also issued proposed rules earlier this year to authorize commodity options, including options in Agricultural Commodities, but excluding options on futures (the “Commodity Options Proposed Rules”), but has elected to postpone finalization of the Commodity Options Proposed Rules until later this year.
Agricultural Swaps (Other than Options)
The Agricultural Swaps Final Rules were approved by a unanimous 5-0 vote of the CFTC commissioners on August 4, 2011 and published in the Federal Register on August 10, 2011 (76 FR 49291). They will become effective as of December 31, 2011 and will result in swaps (other than options) in Agricultural Commodities being authorized under the same regulatory regime that is applicable to other types of swaps under the CFTC’s jurisdiction (including the provisions of the CEA and the rules, regulations, and orders of the CFTC).
In so doing, the Agricultural Swaps Final Rules will eliminate certain historical anomalies and distinctions between agricultural swaps and other types of swaps under the existing framework. Currently, swaps other than agricultural swaps have been traded in reliance on certain provisions of Section 2 of the CEA (as modified by the Commodity Futures Modernization Act of 2000 (the “CFMA”)), which have generally exempted bilateral swaps between sophisticated counterparties from the CFTC’s jurisdiction; agricultural swaps, however, were specifically excluded from such exemptions in the CEA and CFMA5 and have instead been transacted in reliance on the older set of rules found in Part 35 of the CFTC’s regulations6. This bifurcation has resulted in a certain level of additional administrative burden for market participants, who currently must take care to ensure that their agricultural and nonagricultural swaps, and the parties thereto, meet the applicable eligibility requirements under the correct exemptive categories in order to avoid the risk (among others) that a transaction will be deemed an unauthorized off-exchange futures contract.
Agricultural swaps have previously been required to be executed either on a designated contract market designated pursuant to the CEA (a “DCM”) or, if outside a DCM, to be entered into between “eligible swap participants” as defined in Part 35 of the CFTC’s regulations (“ESPs”). Going forward, agricultural swaps executed outside of a DCM will now be permitted between parties that are “eligible contract participants” as defined in Section 1a(18) of the CEA (“ECPs”), a broader category than ESPs and the same category applicable to other swaps. One key distinction between ESPs and ECPs is that an individual can qualify as an ECP if he or she has aggregate assets of $10 million invested on a discretionary basis (or $5 million if entering into the relevant swap to manage the risk associated with an asset or liability of such individual, or one reasonably likely to be acquired), while an individual must have at least $10 million in total assets7 in all cases to qualify as an ESP8.
In addition, certain other requirements under Part 35 that applied to agricultural swaps traded outside a DCM (including that they not be part of a fungible class of agreements standardized as to their material terms or be entered into on a multilateral transaction execution facility, and that creditworthiness of the counterparty must be a material consideration in entering into or determining the terms thereof), but differed slightly from the requirements applicable to other types of swaps, will now be repealed. This will eliminate the need to conduct slightly different due diligence analyses and make and receive different representations.
To avoid uncertainty, the existing Part 35 rules will be repealed and replaced with new Part 35 rules that provide that agricultural swaps may be listed or traded on SEFs or DCMs and will be subject to the other requirements of the CEA as modified by the Dodd-Frank Act and related rulemaking that are applicable to other swaps, including clearing, margin, capital, registration, reporting, documentation, recordkeeping, and business conduct requirements. The CFTC noted that the comments received on its proposed rules overwhelmingly favored the approach taken to harmonize the requirements applicable to agricultural swaps with those applicable to other swaps, and that the Agricultural Swaps Final Rules would eliminate the need to distinguish between agricultural and non-agricultural swaps within the CFTC’s jurisdiction for identifying the law applicable to a transaction. Users of agricultural swaps, including agricultural producers, processors, merchants, handlers, and other market participants, should benefit from the increased legal certainty and streamlined regulatory regime.
Definition of Agricultural Commodity
The rules implementing the definition of “Agricultural Commodities” were approved by a unanimous 5-0 vote of the CFTC commissioners on July 7, 2011 and published in the Federal Register on July 13, 2011 (76 FR 41048). The new definition became effective on September 12, 2011 and sets forth four categories of agricultural swaps, which have been added as a new paragraph (zz) to Part 1.3 of the CFTC’s regulations9:
- Enumerated agricultural commodities: commodities specifically enumerated in Section 1a of the CEA, including wheat, cotton, rice, corn, oats, barley, rye, flaxseed, grain sorghums, mill feeds, butter, eggs, Solanum tuberosum (Irish potatoes), wool, wool tops, fats and oils (including lard, tallow, cottonseed oil, peanut oil, soybean oil and all other fats and oils), cottonseed meal, cottonseed, peanuts, soybeans, soybean meal, livestock, livestock products, and frozen concentrated orange juice – but not onions, which are specifically excluded;
- All other commodities that are, or once were, or are derived from, living organisms, including plant, animal and aquatic life, which are generally fungible, within their respective classes, and are used primarily for human food, shelter, animal feed, or natural fiber;
- Tobacco, products of horticulture, and such other commodities used or consumed by animals or humans as the CFTC may designate; and
- Commodity-based indexes based wholly or principally on underlying agricultural commodities.
In the accompanying release, the CFTC noted that the reference to “oils” in category 1 would include plant-based oils, such as tung oil and linseed oil, which are used solely for industrial purposes, but would not include petroleum products. Petroleum products would also not fall under category 2 (despite being derived from living organisms or fossils thereof), because they are not primarily used for human food, shelter, animal feed, or natural fiber.
In addition, the CFTC clarified that the definition’s references to “used primarily” would mean “any amount of usage over 50 percent.” The release gave an example of peaches being counted by the unit, but did not say whether calculations based on relative volume, weight, or value of the same commodity used for various purposes could be permitted instead.
The Commodity Options Proposed Rules were issued on January 20, 2011 and published in the Federal Register on February 3, 2011 (76 FR 6095). In its release accompanying the publication of the Agricultural Swaps Final Rules, the CFTC had indicated that it would delay finalizing the Commodity Options Proposed Rules until a later date without giving a more specific timetable, but the Agricultural Swaps Final Rules were included in a list of rulemaking areas scheduled to be finalized during the remainder of 2011 (link) that was announced at the CFTC’s public meeting on September 8, 2011.
Pursuant to amendments to the CEA effected by the Dodd-Frank Act, options other than options on futures are included within the definition of “swaps” under the CFTC’s jurisdiction10. If promulgated in their proposed form, the Commodity Options Proposed Rules would make several amendments to Parts 32 and 33 of the CFTC’s regulations in order to update and eliminate duplicative restrictions and exemptions and to make clear that commodity options (other than options on futures) would be permitted under the same post-Dodd-Frank Act regulatory framework applicable to other swaps under the CFTC’s jurisdiction11. As the CFTC observed in its accompanying statement, the Commodity Options Proposed Rules would eliminate the need to distinguish between swaps and options (other than options on futures) for the purpose of identifying the law applicable to a particular transaction. Options on futures, meanwhile, would remain subject to separate regulatory requirements under Part 33 of the CFTC’s regulations.