The Dodd-Frank Wall Street Reform and Consumer Protection Act1 prohibits swaps in an agricultural commodity unless conducted pursuant to a rule or order under the Commodity Futures Trading Commission’s (“CFTC” or “Commission”) 4(c) exemptive authority. In the CFTC’s Notice of Proposed Rulemaking regarding Commodity Options and Agricultural Swaps,2 the Commission proposes to adopt new rules that would expressly require eligible parties that enter into swaps in an agricultural commodity to be subject to the same provisions of the CEA and the CFTC’s regulations that apply to all other commodity swaps. In addition, all over-the-counter commodity option transactions, including options on physical commodities, would be subject to the same requirements that apply to commodity swaps.
Revisions to the CFTC’s Regulations
Under the Proposed Rule, the Commission would remove and then replace Part 35 of the existing regulations in its entirety. It would replace the existing eligible swap participant (“ESP”) requirement with the same eligible contract participant (“ECP”) requirement that applies to all swaps executed outside of a designated contract market (“DCM”) under the Dodd-Frank Act. That is, a market participant will be unable to execute any agriculture swaps other than through a DCM (which will require initial and variable margin to be posted) unless such market participant is an ECP. In order to qualify as an ECP under the Dodd-Frank Act, a party that is a corporation, partnership, proprietorship, organization, or trust must have either total assets exceeding $10,000,000, or a net worth exceeding $1,000,000 if it is entering into the swap in connection with the conduct of its business or to manage a risk associated with an asset or liability of the party (or one reasonably likely to be acquired) in the conduct of its business. Alternatively, this type of party can still qualify as an ECP if their guarantor or credit support provider for the swap meets the definitional requirements. For an individual to qualify as an ECP, the individual must have over $10,000,000 in discretionary investments, or over $5,000,000 in discretionary investments if the swap is being executed to manage a risk associated with an asset or liability of the individual (or one reasonably likely to be acquired). The Commission requests comment as to whether this requirement will adversely affect market participants.
The Commission also proposes several revisions to Part 32 of the CFTC’s regulations. Specifically, the Proposed Rule would revise Rule 32.4 (trade option exemption), to require entities entering into commodity options to be ECPs. While non-ECPs could formerly execute options on nonenumerated agricultural commodities, provided the option was offered to a commercial producer or processor that was entering into the option for hedging purposes, under the proposed revisions to Rule 32.4, both parties will be required to be ECPs. The Commission requests comment as to whether this will significantly affect hedging opportunities available to currently active market participants.
The Commission further proposes to withdraw Rule 32.13 and the Agricultural Trade Option (ATO) exemption, which currently applies to options in enumerated agricultural commodities. The withdrawal of Rule 31.13 would remove the current $10 million net worth requirement that applies to both parties to an option on enumerated agricultural commodities under the current Rule 32.13. Instead, under the Proposed Rule, parties with a net worth of less than $10 million could enter into agricultural trade options as long as they qualify as an ECP.
The Proposed Rule also would withdraw Rule 32.12, commonly known as the “dealer options exemption.” The Commission explains in the Proposed Rule that no participants have used the dealer option since “at least September 11, 2001, and likely for a decade before that.”3 The Commission requests comment as to whether there is any reason not to withdraw and replace Rule 32 in its entirety.
Finally, the CFTC proposes to make various conforming amendments to its rules. For example, the Commission proposes to amend Part 33 to remove references to options on physical commodities, which would instead be regulated as swaps. Under the Proposed Rule, only exchange-traded options on futures would remain subject to Part 33. The Commission does not believe that this change will have any practical effect on participants because anyone (including non-ECPs) could continue to trade physical commodity options on a DCM, while ECPs could trade over-the-counter physical commodity options subject to the same rules as other physical commodity swaps.
In addition, Section 723(c)(3)(B) of the Dodd-Frank Act includes a “grandfather” clause, which provides that any rule, regulation or order regarding agricultural swaps that was issued pursuant to the Commission’s exemptive authority in CEA section 4(c), and was in effect on the date of enactment of the Dodd-Frank Act, will continue to be permitted under such terms and conditions as the CFTC may prescribe. Section 723(c)(3)(B)’s grandfather clause applies to agricultural swaps and calendar swaps entered pursuant to Part 35 of the Commission Regulations, but not to options entered pursuant to Part 32.
Although the CFTC otherwise is conforming its rules to apply the same framework to commodity options as to swaps, it proposes to apply the unlawful representation and anti-fraud rules (Rules 32.8 and 329) to agricultural options, even though they already will be subject to similar provisions applicable to swaps. This revision will give the CFTC’s Division of Enforcement another cause of action for the same violation.
The Proposed Rules likely would become effective sixty days after the Commission issues final regulations, which is unlikely to occur before June or July 2011. The Proposed Rules could have a significant impact on active market participants executing swaps and options on agriculture products, especially if a market participant does not qualify as an ECP. While the full impact of the Proposed Rule cannot be ascertained until certain related rulemakings under the Dodd-Frank Act are promulgated by the CFTC, producers, processors and consumers of agriculture products who actively hedge their price exposure, as well as dealers, should keep abreast of the emerging regulations and consult with their advisors as to the impact such regulations could have on their business. Because the Commission is soliciting comments on the Proposed Rule through April 4, 2011, market participants may want to provide such comments to the CFTC either directly or through an industry association.