The Gift That Keeps On Giving: CFTC’s Misaligned Definition of Forward Contracts Gives Rise to Another Potential Burden on LDCs Under Dodd-Frank Position Limit Rules

In our recent post, “CFTC Forward vs. Trade Option: LDCs Still Struggle as Trade Option Reporting Deadline Looms,” we discussed the unintended impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) on energy industry participants, including natural gas local distribution companies (“LDCs”) that continue to struggle with Commodity Futures Trading Commission (“CFTC”) regulations regarding oversight of swaps transactions.  The CFTC’s current regulations exempt certain energy transactions from Dodd-Frank swaps requirements, but the overbroad definitions of swaps and exempted transactions fail to take into account the industry’s use of transactions that should qualify as forward contracts with volumetric optionality.  The first annual trade option reports required by Dodd-Frank and The Commodity Exchange Act are due to the CFTC on March 1, 2014.  Accordingly, LDCs must classify their transactions, including supply contracts and asset management agreements (“AMAs”), as either forwards that are exempt from regulation under Dodd-Frank or trade options that must be reported under the Act.  Previously, we examined how CFTC regulations should be modified to ensure that LDCs would not have to classify their supply contracts and AMAs as trade options subject to reporting.  Here, we discuss another unintended consequence of the CFTC’s poorly-crafted definition of forward contracts with volumetric optionality which is lurking in the CFTC’s Proposed Rules on Position Limits for Derivatives.  In December 2013, the CFTC proposed new regulations for derivative position limits pursuant to Dodd-Frank.  The proposed rules, which apply to trade options, will set a maximum position in a commodity derivatives contract that may be held or controlled.  Many LDC’s may find themselves exceeding the CFTC’s position limits if trade options are included in the position limit rules, due to the CFTC’s unfortunate definition of forward contracts with volumetric optionality.

Is It a Trade Option?

An option is an agreement that gives one party the right, but not the obligation, to either buy a commodity or sell a commodity to another party. Generally, commodity options are treated as swaps subject to Dodd-Frank regulation. However, if a commodity option qualifies as a trade option, it is exempt from the Dodd-Frank requirement that swaps be traded and executed on an exchange and, under most circumstances, is exempt from the more stringent reporting requirements.  To qualify as a trade option, the offeror must be an Eligible Contract Participant (“ECP”) or a Commercial who is entering into the option solely for business purposes or for a commercial use, and has a reasonable basis to believe that the offeree is a Commercial.  The offeree must be a Commercial, and the trade option must result in physical delivery, if exercised.  An ECP is an entity that has sufficient regulated status or a specified amount of assets. A Commercial is defined as a producer, processor, commercial user of, or a merchant handling the commodity which is the subject of the commodity option.  While exempt from other Dodd-Frank requirements such as Part 45 reporting, trade options still must be reported annually to the CFTC on the form entitled “Annual Notice Filing to Counterparties for Unreported Trade Options” (“Form TO”).

Proposed Position Limit Requirements

The CFTC’s proposed position limit rules set a maximum position in a commodity derivatives contract that may be held or controlled by one person.  Specific initial limits are set forth in the Appendices to the proposed rules, and provision is made for subsequent limits to be set by the CFTC periodically.  As proposed, the rules and limits apply to commodity derivative contracts, defined as “any futures, option, or swap contract in a commodity (other than a security futures product as defined in section 1a(45) of the Act)” and basis contracts, which include trade options.  Accordingly, trade options will be netted with other positions in determining an LDC’s overall position under the proposed rules.  Therefore, an LDC’s trade options could lead to a position that exceeds the limits set by the CFTC, subjecting that position to reporting requirements under the position limit rules.

Hope for a Trade Option Exemption?

Regardless of whether an LDC’s transaction is forced into classification as a trade option due to the poorly crafted definition of forward contract with volumetric optionality (see our previous post for detailed discussion) or the LDC chooses to classify a transaction as a trade option in order to take advantage of the trade option exemption, the trade option will be subject to position limits under the CFTC’s rules as proposed.  There is the possibility, however, that the final position limit rules will exempt trade options.  In the proposed position limit rules, the CFTC expressly requested comments on whether trade options should be exempted, stating:

Further, the Commission requests comment on whether it would be appropriate to exclude trade options from the definition of referenced contracts and, thus, to exempt trade options from the proposed position limits. If trade options were excluded from the definition of reference contracts, then commodity derivative contracts that offset the risk of trade options would not automatically be netted with such trade options for purposes of non-spot month position limits. The Commission notes that forward contracts are not subject to the proposed position limits; however, certain forward contracts may serve as the basis of a bona fide hedging position exemption, e.g., an enumerated bona fide hedging position exemption is available for the offset of the risk of a fixed price forward contract with a short futures position. Should the Commission include trade options as one of the enumerated exemptions (e.g., proposed paragraphs (3)(ii) and (iii) of the definition of bona fide hedging position under proposed § 150.1)?

A full exemption for trade options is not the only possibility.  The CFTC also presented an alternative for public consideration: “As an alternative to excluding trade options from the definition of referenced contract, should the Commission provide an exemption under CEA section 4a(a)(7) that permits the offeree or offeror to submit a notice filing to exclude their trade options from position limits? If so, why and under what circumstances?”  Additional factors that will weigh into the CFTC’s decision on whether to modify the proposed rules to accommodate trade options include whether “there any other characteristics of trade options or the parties to trade options that the Commission should consider” and whether “any of these alternatives permit commodity options that should be regulated as swaps to circumvent the protections established in the Dodd-Frank Act for the forward contract exclusion for non-financial commodities?”  The comments period closed on February 10, 2014.  As anticipated, most energy industry participants and trade associations (such as the American Gas Association (“AGA”)) argued strenuously for full exemption of commodity trade options. You can access the comments submitted in response to the CFTC’s proposed rules online.  We will keep you posted on developments and when the CFTC issues the final rule.