The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) added provisions to the Commodity Exchange Act (“CEA”) regarding the regulatory oversight of swaps transactions that have imposed unintended and burdensome consequences on energy industry participants, including natural gas local distribution companies (“LDCs”). Although the regulations adopted by the Commodity Futures Trading Commission (“CFTC”) have carved out exceptions that are meant to exempt certain energy commodity transactions from the Dodd-Frank swaps requirements, the overbroad definitions of swaps and the excepted transactions do not adequately take into consideration the industry’s use of forward contracts with volumetric optionality and the regulatory obligations that inform LDC’s decisions in operating under such contracts. The first annual trade option reports are due to the CFTC on March 1, 2014, and LDCs continue to struggle with classifying their transactions as forwards that are exempt from regulation under Dodd-Frank or trade options that must be reported under the Act. In his January 27, 2014 keynote address at the Commodity Markets Council State of the Industry 2014 Conference, CFTC Commissioner Scott D. O’Malia identified the test for determining whether a contract qualifies as a forward contract with volumetric optionality among the areas of CFTC regulation that are “candidates for rule revisions.” According to Commissioner O’Malia “the Commission must make the necessary adjustment to improve our rules when we encounter unexpected outcomes of our rulemakings. In fact, it would be irresponsible of the Commission to ignore problems and to continue implementing its unworkable regulations.” We will look at the unexpected and unworkable aspects of the CFTC swaps regulations as applied to the natural gas industry, and where the regulations should be modified.
Definition of Swap
Pursuant to Section 721 of the Dodd-Frank Act, the CEA defines a “swap” as including “[an] option of any kind that is for the purchase or sale, or based on the value, of 1 or more . . . commodities . . . .” While commodity options generally are regulated as swaps, forward contracts are generally outside of the CFTC’s jurisdiction: CEA § 1a(47)(B)(11) excludes “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 CFTC regulations further define swaps to exclude some forward contracts that contain elements of optionality.
Forward Contracts w/ Elements of Optionality
If an instrument qualifies as a forward under Dodd-Frank, it is not subject to the Act’s requirements. Commodity options or agreements where the optionee has the right, but not the obligation to make or take delivery, are not forwards (forwards are agreements where both parties have the obligation to make or take delivery). Rather, commodity options are swaps and are subject to Dodd-Frank. However, CFTC regulations provide that a forward with embedded volumetric optionality can qualify as a forward and be exempt from Dodd-Frank even though it has an element of optionality. To qualify, the following seven factors must be met:
- 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 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 it exercises the embedded volumetric optionality;
- Both parties are commercial parties; and
- The 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.
The Problem: The 7th Factor is Misaligned with Industry Custom & Regulatory Requirements
The seventh factor of the volumetric optionality test presents challenges for the natural gas industry, particularly for LDCs operating under countervailing regulatory requirements to obtain the best price on natural gas in order to minimize the costs directly passed through to consumers. In fulfilling the regulatory requirement to obtain favorable pricing, LDCs may use economic conditions as a factor to determine which supply they use on a daily basis. This has raised questions in the industry as to whether LDCs choosing whether or not to exercise the embedded volumetric optionality in their supply contracts are doing so “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,” as required to qualify as a forward contract. If not, then most gas supply contracts utilized by LDCs may be considered trade options that are subject to Dodd-Frank regulation, despite the intent to exclude such routine energy supply contracts from the reach of the Act. The industry also employs Asset Management Agreements (“AMAs”) under which LDCs release pipeline capacity to marketers along with an obligation that the marketer deliver quantities equal to the maximum daily demand for that capacity (for at least five months of the year). Unless these contracts are considered requirements contracts, LDC’s still find themselves in a difficult position to categorize AMA’s as forward contracts with volumetric optionality under the current definition.
The Solution: Modification of the 7th Factor to Acknowledge Industry Use of Contracts with Volumetric Optionality
The burden on energy industry participants comes not only from the necessity to comply with Dodd-Frank (even though not intended by the Act), but also from the necessity to navigate the uncertainties generated by the CFTC’s vague regulations. So, where should the CFTC make revisions? The CFTC should revise the seventh factor of the volumetric optionality test to reflect the reality of energy industry participant use of volumetric optionality in supply contracts and AMAs. The criterion should be revised to clarify that a contract qualifies as a forward that is exempt from Dodd-Frank (1) if the exercise of embedded volumetric optionality is based on regulatory requirements that include a goal of seeking the best price for the commodity, and (2) in the case of an AMA, if the contract states that delivery of natural gas is the primary objective.
CFTC Commissioner O’Malia acknowledged last week that the CFTC seven-part test is severely out-of-line with the reality of how energy market participants operate, stating:
end-users have been struggling to decipher the Commission swap definition rules to determine whether and under what conditions a forward contract with embedded volumetric optionality falls within the forward exclusion….under the seventh factor, contracts with embedded volumetric optionality may qualify for the forward contract exclusion only if exercise of the optionality is based on physical factors that are outside the control of the parties. This is in complete contradiction as to how volumetric options have been traditionally used by market participants.
Commissioner O’Malia recognized the need for the CFTC to change the regulations to reflect the intent of Dodd-Frank: “We need to fix the definition and create reliable and well-defined safe harbors. I also note that both Senators Lincoln and Dodd believe these contracts should not be captured by the swap definition.”
Although the reporting requirements for trade options involving commodities are less burdensome than full regulation of swaps under Dodd-Frank, the intent of the regulation was to exclude supply contracts and AMAs altogether. CFTC Commissioner O’Malia pointed out in his January 27th keynote address that the Senators sponsoring Dodd-Frank “emphasized the importance of allowing end-users to continue to hedge commercial risk and ensuring that Dodd-Frank regulatory reform does not make this legitimate activity prohibitively expensive.” However, the CFTC has failed to provide adequate protections for end-users and “[they] must spend far too much time and resources in order to get the necessary reassurance from the Commission that they are in fact entitled to the protection that Congress afforded them in Dodd-Frank.” The current seventh factor “is in contradiction to how volumetric options have been traditionally used by market participants, makes no sense and provides absolutely no certainty for market participants.” See CFTC Commissioner O’Malia’s October 17, 2013 Edison Electric Institute CFTC Compliance Forum Keynote Address. It is time for the CFTC to revisit its regulations to provide more certainty and the protections intended for the natural gas industry. If the CFTC fails to do so, in the words of Commissioner O’Malia, “I would encourage Congress to revisit the statute.”