[Federal Register Volume 79, Number 224 (Thursday, November 20, 2014)]

[Proposed Rules]

[Pages 69073-69078]

From the Federal Register Online via the Government Printing Office [www.gpo.gov]

[FR Doc No: 2014-27285]

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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 1

RIN 3038-AE24

SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 230, 240 and 241

[Release No. 33-9681; 34-73584; File No. S7-16-11]

RIN 3235-AK65

Forward Contracts With Embedded Volumetric Optionality

AGENCY: Commodity Futures Trading Commission; Securities and Exchange

Commission.

ACTION: Proposed interpretation.

———————————————————————–

SUMMARY: In accordance with section 712(d)(4) of the Dodd-Frank Wall

Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), the

Commodity Futures Trading Commission (the “CFTC”) and the Securities

and Exchange Commission (“SEC”), after consultation with the Board of

Governors of the Federal Reserve System (“Board of Governors”), are

jointly issuing the CFTC’s proposed clarification of its interpretation

concerning forward contracts with embedded volumetric optionality. The

CFTC invites public comment on all aspects of its proposed

interpretation.

DATES: Comments must be received on or before December 22, 2014.

ADDRESSES: You may submit comments, identified by RIN number 3038-AE24,

by any of the following methods:

CFTC Web site: at http://comments.cftc.gov. Follow the

instructions for submitting comments through the Web site.

Federal eRulemaking Portal: http://www.regulations.gov.

Follow the instructions for submitting comments.

Mail: Secretary of the Commission, Commodity Futures

Trading Commission, Three Lafayette Centre, 1155 21st Street NW.,

Washington, DC 20581.

Hand Delivery/Courier: Same as Mail, above. Please submit

your comments using only one method.

All comments must be submitted in English, or if not, accompanied

by an English translation. Comments will be posted as received to

www.cftc.gov. You should submit only information that you wish to make

available publicly. If you wish the CFTC to consider information that

you believe is exempt from disclosure under the Freedom of Information

Act, a petition for

[[Page 69074]]

confidential treatment of the exempt information may be submitted

according to the procedures established in Sec. 145.9 of the CFTC’s

regulations, 17 CFR 145.9.

The CFTC reserves the right, but shall have no obligation, to

review, pre-screen, filter, redact, refuse or remove any or all of a

submission from http://www.cftc.gov that it may deem to be

inappropriate for publication, such as obscene language. All

submissions that have been redacted or removed that contain comments on

the merits of the notice will be retained in the public comment file

and will be considered as required under all applicable laws, and may

be accessible under the Freedom of Information Act.

FOR FURTHER INFORMATION CONTACT: CFTC: Elise Pallais, Attorney Advisor,

(202) 418-5577, [email protected], Office of the General Counsel,

Commodity Futures Trading Commission, 1155 21st Street NW., Washington,

DC 20581. SEC: Carol McGee, Assistant Director, (202) 551-5870,

[email protected], Office of Derivatives Policy, Division of Trading and

Markets, Securities and Exchange Commission, 100 F Street NE.,

Washington, DC 20549.

SUPPLEMENTARY INFORMATION:

I. Introduction

In Further Definition of “Swap,” Security-Based Swap,” and

“Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap

Agreement Recordkeeping (the “Products Release”), the CFTC provided

an interpretation, in response to requests from commenters, with

respect to forward contracts that provide for variations in delivery

amount (i.e., that contain “embedded volumetric optionality”).1

Specifically, the CFTC identified when an agreement, contract, or

transaction would fall within the forward contract exclusion from the

“swap” and “future delivery” definitions in the Commodity Exchange

Act (the “CEA”) 2 notwithstanding that it contains embedded

volumetric optionality.3 In providing its interpretation, the CFTC

was guided by and sought to reconcile agency precedent regarding

forward contracts containing embedded optionality 4 with the

statutory definition of “swap” in section 1a(47) of the CEA, which

provides, among other things, that commodity options are swaps, even if

physically settled.5

—————————————————————————

1 See 77 FR 48207, 48238-42 (Aug. 13, 2012).

2 See 7 U.S.C. 1a(47)(B)(ii) (excluding from the definition of

“swap” “any sale of a nonfinancial commodity or security for

deferred shipment or delivery, so long as the transaction is

intended to be physically settled”); 1a(27) (excluding from the

definition of “future delivery” “any sale of any cash commodity

for deferred shipment or delivery”).

3 See 77 FR 48238-42 & n.335. See also id. at 48227-36

(providing the CFTC’s interpretation regarding the forward contract

exclusion for nonfinancial commodities).

4 See id. at 48237-39 (citing In re Wright, CFTC Docket No.

97-02, 2010 WL 4388247 (CFTC Oct. 25, 2010), and Characteristics

Distinguishing Cash and Forward Contracts and “Trade” Options, 50

FR 39656 (Sept. 30, 1985) (“1985 CFTC OGC Interpretation”)).

5 See id. at 48236-37; 7 U.S.C. 1a(47)(A)(i) (defining

“swap” to include “[an] option of any kind that is for the

purchase or sale, or based on the value, of 1 or more . . .

commodities . . .”) (emphasis added). Part 32 of the CFTC’s

regulations includes an exemption for certain physically settled

options, termed “trade options.” See 17 C.F.R. 32.3. The trade

option exemption is currently subject to CFTC staff no-action

relief. See CFTC Letter No. 13-08 (April 5, 2013), available at

http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/13-08.pdf.

—————————————————————————

The CFTC has received several comments from market participants

requesting that it modify or further clarify its interpretation.6

According to commenters, uncertainty with regard to the meaning of

certain language in the CFTC’s interpretation, particularly the seventh

element, has led to confusion among market participants with regard to

how to characterize certain transactions, whether as excluded forward

contracts with embedded volumetric optionality or regulated trade

options.

—————————————————————————

6 The Products Release included a request for comment on the

CFTC’s interpretation. See 77 FR 48241-42. CFTC staff also solicited

comments in connection with a public roundtable to discuss issues

concerning end users and the Dodd-Frank Act. These comments are

available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1256 and http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1485, respectively.

—————————————————————————

II. Proposed Interpretation

In response to commenters, the CFTC is proposing to clarify its

interpretation of when an agreement, contract, or transaction with

embedded volumetric optionality would be considered a forward

contract.7 Accordingly, the CFTC is proposing to provide that an

agreement, contract, or transaction falls within the forward exclusion

from the swap and future delivery definitions, notwithstanding that it

contains embedded volumetric optionality, when:

—————————————————————————

7 Section 712(d)(4) provides that “[a]ny interpretation of,

or guidance by either Commission regarding, a provision of this

title, shall be effective only if issued jointly by the Commodity

Futures Trading Commission and the Securities and Exchange

Commission, after consultation with the Board of Governors, if this

title requires the Commodity Futures Trading Commission and the

Securities and Exchange Commission to issue joint regulations to

implement the provision.” While the Dodd-Frank Act would require

this interpretation to be issued jointly by the CFTC and the SEC, it

would be an interpretation solely of the CFTC and would not apply to

the exclusion from the swap and security-based swap definitions for

security forwards or to the distinction between security forwards

and security futures products.

—————————————————————————

1. The embedded optionality does not undermine the overall nature

of the agreement, contract, or transaction as a forward contract;

2. The predominant feature of the agreement, contract, or

transaction is actual delivery;

3. The embedded optionality cannot be severed and marketed

separately from the overall agreement, contract, or transaction in

which it is embedded;

4. 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 embedded

volumetric optionality is exercised;

5. 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 the embedded

volumetric optionality is exercised;

6. Both parties are commercial parties; and

7. The embedded volumetric optionality is primarily intended, at

the time that the parties enter into the agreement, contract, or

transaction, to address physical factors or regulatory requirements

that reasonably influence demand for, or supply of, the nonfinancial

commodity.

The first six elements are largely unchanged from the Products

Release.8 Among them, the CFTC is proposing to modify only the fourth

and fifth elements, to clarify that the CFTC’s interpretation applies

to embedded volumetric optionality in the form of both puts and

calls.9 Accordingly, the CFTC’s discussion of these six elements in

the Products Release would remain relevant and applicable.10

—————————————————————————

8 See 77 FR 48238.

9 As described in the Products Release, the fifth element did

not appear to contemplate circumstances where the seller of the

nonfinancial commodity might exercise the embedded volumetric

optionality. See 77 FR 48238 (“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.”) (emphasis added).

10 See 77 FR 48238-39.

—————————————————————————

The seventh element addresses the primary reason for including

embedded

[[Page 69075]]

volumetric optionality in a forward contract. As commenters have

explained, commercial parties are often unable to accurately predict

their exact delivery needs or production capacity for a given

nonfinancial commodity at contract initiation due to a variety of

factors, such as weather and certain other “operational

considerations” (e.g., transportation capacity).11 The embedded

volumetric optionality therefore offers commercial parties the

flexibility to vary the amount of the nonfinancial commodity delivered

during the life of the contract in response to uncertainty in the

demand for or supply of the nonfinancial commodity.12

—————————————————————————

11 See, e.g., Letter from ONEOK, Inc. (July 22, 2011) at 4

(stating that “day-to-day changes in demand” for natural gas “may

be caused by variation in weather, operational considerations, or

other factors”); Letter from the American Gas Association (Oct. 12,

2012) at 9 (stating that “weather-sensitive demands” for natural

gas “cannot be accurately predicted in advance”).

12 See, e.g., Letter from the Commodity Markets Council, the

National Corn Growers Association, and the Natural Gas Supply

Association (April 17, 2014) at 2 (“Physical end-users need these

contracts to address supply input or production output uncertainty

associated with the operation of a physical business.”); Letter

from the Plains All American Pipeline, L.P. (April 17, 2014) at 2

(“Such contracts provide us with the ability to allow our customers

flexibility to increase or decrease the amount of purchase or sale

of a commodity in response to prevailing market conditions.”).

—————————————————————————

The seventh element ensures that this purpose, consistent with the

historical interpretation of a forward contract,13 is the primary

purpose for including embedded volumetric optionality in the contract.

In other words, the embedded volumetric optionality must primarily be

intended as a means of assuring a supply source or providing delivery

flexibility in the face of uncertainty regarding the quantity of the

nonfinancial commodity that may be needed or produced in the future,

consistent with the purposes of a forward contract.14

—————————————————————————

13 See 77 FR 48228 (describing a forward contract as a

“commercial merchandising transaction” in which delivery is

delayed for “commercial convenience or necessity”).

14 See 77 FR 48228 (“The primary purpose of a forward

contract is to transfer ownership of the commodity and not to

transfer solely its price risk.”). See also Letter from the

Commodity Markets Council, the National Corn Growers Association,

and the Natural Gas Supply Association (April 17, 2014) at 2

(“[Contracts with volumetric optionality] exist to permit end-users

to have agreements in place so that they can effectively and

economically manage the purchase or sale of commodities related to

their commercial businesses, not as a substitute for a financially

settled contract or for speculative purposes.”); Letter from ONEOK,

Inc. (July 22, 2011) at 7 (“Although the amounts that can be taken

on delivery may vary, the primary intent of the contracts is not to

provide price protection, which is clearly the intent of the

contracts described in the [1985 CFTC] OGC Interpretation as trade

options.”).

—————————————————————————

In response to commenters, the CFTC is proposing to modify the

seventh element to further clarify its interpretation.15 To begin,

the CFTC is proposing to remove reference to the “exercise or non-

exercise” of the embedded volumetric optionality. This language was

included to embody the longstanding principle, recognized by

commenters, that intent may be ascertained by the relevant facts and

circumstances surrounding the contract, including the parties’ course

of performance thereunder.16 According to commenters, however, this

language has created problems during contract negotiations, because

certain parties feel pressure to specify the exact factors that could

lead to the exercise or non-exercise of the volumetric optionality.17

By removing this language, the CFTC intends to clarify that the focus

of the seventh element is intent with respect to the embedded

volumetric optionality at the time of contract initiation.18 The CFTC

would further advise commercial parties that they may rely on

counterparty representations with respect to the intended purpose for

embedding volumetric optionality in the contract, provided they are

unaware, and should not reasonably have been aware, of facts indicating

a contrary purpose.

—————————————————————————

15 As stated in the Products Release, the seventh element

reads as follows:

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.

77 FR 48238 (footnotes omitted).

16 See 77 FR 48228 (“In assessing the parties’ expectations

or intent regarding delivery, the CFTC consistently has applied a

`facts and circumstances’ test.”); Letter from ONEOK, Inc. (July

22, 2011) at 6 (“The intent of the parties to defer delivery of a

varying amount can be ascertained based on objective criteria, such

as the pattern of deliveries in relation to variation in weather,

customer demand, or other similar factors.”).

17 See, e.g., Letter from the Commodity Markets Council, the

National Corn Growers Association, and the Natural Gas Supply

Association (April 17, 2014) at 2 & n.3 (stating that commercial

parties are “being asked for vague (and, therefore, potentially

unenforceable) representations” because “the question of the

reason for exercise of volumetric optionality can vary from

transaction to transaction and is not known until the time of

exercise”); Letter from the American Gas Association (April 17,

2014) at 10 (citing “widespread confusion as to whether

counterparties must demonstrate forward contract status as of the

time of entering into an agreement, or as of the time of exercise or

non-exercise of delivery rights under the agreement.”).

18 For example, in choosing whether to obtain additional

supply by exercising the embedded volumetric optionality under a

given contract or turning to another supply source–whether storage,

the spot market, or another forward contract with embedded

volumetric optionality–commercial parties would be able to consider

a variety of factors, including price, provided that the intended

purpose for including the embedded volumetric optionality in the

contract at contract initiation was to address physical factors or

regulatory requirements influencing the demand for or supply of the

commodity.

—————————————————————————

The CFTC is also proposing to remove reference to physical factors

or regulatory requirements being “outside the control of the

parties.” This phrase was taken from commenter letters 19 but has

also apparently created problems during contract negotiations, as

counterparties often disagree about the degree of control they have

over factors influencing their demand for or supply of the nonfinancial

commodity.20 By removing this language, the CFTC intends to clarify

that whether the parties have some influence over factors affecting

their demand for or supply of the nonfinancial commodity (e.g., the

scheduling of plant maintenance, plans for business expansion) would

not be inconsistent with the seventh element of the CFTC’s

interpretation, provided that the embedded volumetric optionality is

included in the contract at initiation primarily to address potential

variability in a party’s supply of or demand for the nonfinancial

commodity.

—————————————————————————

19 See Letter from BG Americas & Global LNG (July 22, 2011) at

4 (“Variability associated with an energy customer’s physical

demand is influenced by factors outside the control of the energy

suppliers (and sometimes the consumers) . . .”); Letter from the

Working Group of Commercial Energy Firms (July 22, 2011) at 8

(“Availability of production and requirements for consumption are

often influenced by factors outside the control of the parties to an

energy commodity transaction and can change on an hourly or daily

basis.”) (emphasis added).

20 Letter from the Plains All American Pipeline, L.P. (April

17, 2014) at 3 (“[M]any counterparties understand the [seventh

element] to have failed when a counterparty has more than one

alternative to meet its physical commodity needs, therefore making

the choice of supply `within its control.”’); Letter from the

Commodity Markets Council, the National Corn Growers Association,

and the Natural Gas Supply Association (April 17, 2014) at 2-3

(listing as an issue stemming from the ambiguity in the seventh

element “uncertainty as to whether end-users with more than one

supply choice are always exercising optionality within their

control”).

—————————————————————————

The CFTC is also proposing to clarify that the phrase “physical

factors” should be construed broadly to include any fact or

circumstance that could reasonably influence supply of or demand for

the nonfinancial commodity under the contract. Such facts and

circumstances could include not only environmental factors, such as

weather or location, but relevant “operational considerations” (e.g.,

the availability of reliable transportation or technology) and broader

social forces, such as changes in demographics or geopolitics.21

Concerns that are

[[Page 69076]]

primarily about price risk (e.g., expectations that the cash market

price will increase or decrease), however, would not satisfy the

seventh element absent an applicable regulatory requirement to obtain

or provide the lowest price (e.g., the buyer is an energy company

regulated on a cost-of-service basis).22

—————————————————————————

21 The CFTC reiterates that, as stated in the Products

Release, system reliability issues that lead to voluntary supply

curtailments would be considered “physical factors” within the

scope of the seventh element. See 77 FR 48239 n.345.

22 See Letter from the Office of the General Counsel, Federal

Energy Regulatory Commission (Oct. 12, 2012) at 4. The CFTC confirms

that, as stated in the Products Release, the deliverable quantities

allowable under embedded volumetric optionality may be justified by

a combination of regulatory requirements and physical factors, such

that the quantity provided for by the embedded volumetric

optionality may reasonably exceed quantities required by regulation.

See 77 FR 48238 n.340.

—————————————————————————

The CFTC understands that in certain retail electric market demand-

response programs, electric utilities have the right to interrupt or

curtail service to a customer to support system reliability.23 The

CFTC is proposing to clarify that, given that a key function of an

electricity system operator is to ensure grid reliability, demand

response agreements, even if not specifically mandated by a system

operator, may be properly characterized as the product of regulatory

requirements within the meaning of the seventh element.24

—————————————————————————

23 See Letter from the National Rural Electric Cooperative

Association, the American Public Power Association, the Large Public

Power Association, and the Transmission Access Policy Study Group

(Oct. 12, 2012) at 9.

24 The CFTC clarifies that its interpretations regarding full

requirements and output contracts, as provided in the Products

Release, would be unaffected by the discussion herein. See 77 FR

48239-40. Similarly, the CFTC reiterates that, depending on the

relevant facts and circumstances, capacity contracts, transmission

(or transportation) service agreements, tolling agreements, and

peaking supply contracts, as discussed in the Products Release, may

qualify as forward contracts with embedded volumetric optionality

provided they meet the elements of the CFTC’s proposed

interpretation. See 77 FR 48240.

—————————————————————————

III. Request for Comment

The CFTC believes that it would benefit from public comment about

its proposed interpretation, and therefore requests public comment on

all aspects of its proposed interpretation regarding forwards with

embedded volumetric optionality, and on the following questions:

1. Market participants have expressed concerns about whether

various types of volumetric optionality fit within the CFTC’s

interpretation. The CFTC recognizes that, since the interpretation is

not intended to provide relief for all forms of embedded volumetric

optionality, there are likely to remain concerns within the industry

about the treatment of embedded volumetric optionality within forward

contracts.

The CFTC notes that, in April, 2012, the CFTC adopted an Interim

Final Rule for Commodity Options (the “IFR”).25 Even if a contract

with volumetric optionality does not fit within the seven elements of

the interpretation, the CFTC believes there is widespread agreement

that contracts that fail one or more of the seven elements of the

CFTC’s interpretation would fall within the exemption from most swaps

regulation provided by the IFR. Therefore, it appears that the IFR

provides a clear and well-understood mechanism through which contracts

with volumetric optionality can be exempted that avoids many of the

difficulties of determining whether a particular contract with

volumetric optionality would satisfy the seven elements of the CFTC’s

interpretation.

—————————————————————————

25 See 77 FR 25320 (April 27, 2012).

—————————————————————————

The CFTC invites comment on whether the IFR’s approach to defining

the universe of swaps subject to its exemption may provide a clearer

and easier mechanism for providing relief from swaps requirements than

the CFTC’s interpretation of forwards with embedded volumetric

optionality and whether the IFR currently provides sufficient relief

for such contracts.

2. Market participants have argued that the lack of clarity around

the seventh element of the CFTC’s interpretation has led to costs to

end-users. Conceivably, since contracts that fail one or more of the

seven elements would be regulated as exempt commodity trade options

under the IFR, these costs are attributable to complying with the IFR.

The CFTC invites comment on whether or not this is the case, and

invites the submission of data quantifying those costs.

3. What factors should the CFTC consider in determining whether the

proposed modifications and clarifications to the CFTC’s interpretation

are appropriate in view of CFTC precedent regarding the interpretation

of the CEA’s forward contract exclusion? Do the proposed changes

provide sufficient clarity on how contracts with embedded volumetric

optionality may satisfy all seven elements of the interpretation,

particularly the first and second elements? Are there reasons why

trying to provide further relief through the swap definition’s forward

contract exclusion would not be in the public interest?

By the Securities and Exchange Commission.

Brent J. Fields,

Secretary.

Dated: November 13, 2014.

Issued in Washington, DC, on November 13, 2014, by the Commodity

Futures Trading Commission.

Christopher J. Kirkpatrick,

Secretary of the Commission.

Commodity Futures Trading Commission (CFTC) Appendices to Forward

Contracts With Embedded Volumetric Optionality–Commission Voting

Summary, Chairman’s Statement, and Commissioners’ Statements

Appendix 1–Commodity Futures Trading Commission Voting Summary

On this matter, Chairman Massad and Commissioners Wetjen, Bowen,

and Giancarlo voted in the affirmative. No Commissioner voted in the

negative.

Appendix 2–Statement of CFTC Chairman Timothy G. Massad

I support the Staff’s proposed interpretation regarding forward

contracts that have what is known as embedded volumetric

optionality–generally speaking, contracts to buy or sell a

nonfinancial commodity for deferred delivery that provide for

variations in delivery amount.

One of my priorities has been to fine-tune our rules to make

sure they work as intended and do not impose undue burdens or

unintended consequences, particularly for the nonfinancial

commercial businesses that use these markets to hedge commercial

risks. We must make sure these businesses–whether they are

manufacturers, farmers, ranchers or other companies–can continue to

use these markets efficiently and effectively.

This proposal is part of that effort. In certain situations,

commercial parties are unable to predict at the time a contract is

entered into the exact quantities of the commodity that they may

need or be able to supply, and the embedded volumetric optionality

offers them the flexibility to vary the quantities delivered

accordingly. The CFTC put out an interpretation, consisting of seven

factors, to provide clarity as to when such contracts would fall

within the forward contract exclusion from the swap definition, but

some market participants have felt this interpretation, in

particular the seventh factor, was hard to apply. In some cases, the

two parties would reach different conclusions about the same

contract.

Today we are proposing clarifications to the interpretation that

I believe will alleviate this ambiguity and allow contracts with

volumetric optionality that truly are intended to address

uncertainty with respect to the parties’ future production capacity

or delivery needs, and not for speculative purposes or as a means to

obtain one-way price protection, to fall within the exclusion.

[[Page 69077]]

Appendix 3–Statement of CFTC Commissioner Mark P. Wetjen

This proposal further clarifying the definition of forward

contracts with embedded volumetric optionality, or EVO, is intended

to provide commercial firms the regulatory clarity they have sought

since the original release of the seven-part test in August 2012.

The definition of a swap in the Commodity Exchange Act includes

commodity options, but excludes from that definition forward

contracts.26 There was a policy reason for this, and at its root

was a desire to ensure that Dodd-Frank captured many swaps, and

swap-like contracts, that were structured to be similar to options,

while also ensuring that a new regulatory regime was not

inadvertently and inappropriately extended into certain physical

markets.

—————————————————————————

26 7 U.S.C. 1a(47).

—————————————————————————

The broad definitional language in question was designed to

ensure that financial–as opposed to physical–contracts could not

be structured or re-characterized to avoid the new market structure.

While the swap definition does not expressly exclude options on

energy and agricultural commodities, it does exclude both futures

and forwards. I am confident Congress did not intend to pull

contracts that historically have been treated as forwards into the

new swap regime solely because of optionality in the amount of the

physical commodity delivered under the contract.

As a policy matter, Congress surely recognized that the swap

definition had to reflect a long-held Commission belief that

contracts that are physically settled, and where delivery is

required, do not pose the same systemic threats to the financial

system as contracts used for speculative purposes. Moreover,

Congress expanded the Commission’s fraud 27 and anti-manipulation

authority 28 over markets where forward contracts are traded, and

left intact the Commission’s surveillance authority to issue special

calls to market participants for all positions and transactions

related to a commodity.29

—————————————————————————

27 7 U.S.C. 9(c)(1) (“It shall be unlawful for any person,

directly or indirectly, to use or employ, or attempt to use or

employ, in connection with . . . a contract of sale of any commodity

in interstate commerce . . . any manipulative or deceptive device or

contrivance, in contravention of such rules and regulations as the

Commission shall promulgate . . .”.). See also 17 CFR Part 180.

28 7 U.S.C. 9(c)(3) (“[I]t shall be unlawful for any person,

directly or indirectly, to manipulate or attempt to manipulate the

price . . . of any commodity in interstate commerce. . .”).

29 17 CFR 18.05(b) (maintenance of books and records

concerning positions and transactions in the cash commodity); 17 CFR

1.31 (pursuant to Sec. 1.31(2), the authority to request

information required to be kept in accordance with the Act or

Commission regulations); 17 CFR 1.35 (pursuant to Sec. 1.35(3), the

authority to request from a futures commission merchant, retail

foreign exchange dealer, introducing broker or member of a

designated contract market or swap execution facility records

required to be kept by Sec. 1.35 in accordance with the

requirements of Sec. 1.31); 17 CFR 23.203 (pursuant to Sec.

23.203(a), the authority to request and receive within 72 hours any

records required to be kept by a swap dealer or major swap

participant by the Act and by Commission regulations and pursuant to

Sec. 23.203(2), the authority to request records of any swap or

related cash or forward transaction); 17 CFR 23.606 (pursuant to

Sec. 23.606(c), the authority to request information that a swap

dealer or major swap participant is required to maintain under Sec.

23.606(a)(1)); 17 CFR 45.2 (pursuant to Sec. 45.2(h), the authority

to request from swap execution facilities, designated contract

markets, derivatives clearing organizations, swap dealers, and major

swap participants records required to be kept pursuant to Sec.

45.2.); 17 CFR 46.2 (the authority, pursuant to Sec. 46.2(e), to

request records relating to pre-enactment and transition swaps in

existence on or after April 25, 2011).

—————————————————————————

As mentioned, in resolving to adopt the appropriate regulatory

treatment of forward contracts with EVO, the Commission also must

weigh the operational and compliance consequences of that treatment.

Indeed, the Commission should bring a heightened sensitivity to

these considerations in the context of the power sector because

affordable electricity and heat are such fundamental needs of modern

life.

The Commission’s 2012 interpretation, while intended to be

helpful, contained certain ambiguities in the seven-part test that

created confusion among commercial end-users.

Last spring, the Commission learned at a public roundtable that

some market participants may have withdrawn from the market due to

those ambiguities, resulting in inferior execution for commercial

firms. It is difficult to measure the exact impact of this

phenomenon, but apparently it has not been a positive one for

consumers of electricity and gas.

A. Ambiguity in the Seven-Part Test

In discussing the seven-part test, commentators zeroed in on two

primary issues. First, many of the roundtable participants noted

that the exercise or non-exercise of volumetric optionality depends

on a number of factors,30 some of which will be outside of the

control of the parties, and some that will not.

—————————————————————————

30 Letter from The Edison Electric Institute (“EEI”) and the

Electric Power Supply Association (“EPSA”) (April 17, 2014)

(“EEI/EPSA Letter”) at 3 (“The exercise or non-exercise of

volumetric optionality under a forward energy contract depends on a

number of factors, including but not limited to, any or all of the

following: (1) The level of demand as affected by weather or market

conditions; (2) the amount of unexercised volume remaining under the

contract; (3) the time of the change in the level of demand relative

to delivery scheduling capabilities, (4) anticipated future weather

conditions, (5) the delivery location under the contract relative to

the demand location; (6) the price and availability of

transportation capacity (e.g. pipeline capacity) to move natural

gas; (7) the price of alternative sources of supply; (8) the

availability of natural gas or electricity in the spot market; and/

or (9) the remaining inventory of the commodity in storage.”).

—————————————————————————

Many also noted that parties could reasonably disagree on

whether, and the degree to which, a factor is outside of the control

of the parties. For example, having choice among more than one

source of supply, or selecting from those choices the lowest-priced

contract, to some commercial firms caused the contract to fail the

seventh prong.

This ambiguity contributed to a second issue–market

participants stated that they often do not know the exact reasons

that optionality will be exercised until the time of exercise. In

other words, parties are uncertain how to characterize contracts at

the time of execution, and how intent at the time of exercise or

non-exercise might affect that analysis.31

—————————————————————————

31 Letter from the American Gas Association (April 17, 2014)

(“AGA Letter”) at 10 (citing “widespread confusion as to whether

counterparties must demonstrate forward contract status as of the

time of entering into an agreement, or as of the time of exercise or

non-exercise of delivery rights under the agreement.”).

—————————————————————————

The seventh factor’s ambiguity has caused a host of problems.

For instance, parties have been asked to provide vague and possibly

unenforceable representations in agreements.32 Parties also often

disagree about the proper categorization of a transaction, resulting

in them “agreeing to disagree” and considering the same

transaction to be, at the same time, a swap, trade option, or a

forward with EVO.33 This has had the unintended consequence of

distorting transaction data reported to the Commission.34

—————————————————————————

32 AGA Letter at 2; EEI/EPSA letter at 3.

33 NFP Electric Associations Letter at 3.

34 EEI/EPSA letter at 3.

—————————————————————————

The bottom line is that such uncertainty in the seven-part test

increased transaction costs for commercial firms and limited their

access to an effective risk-management tool.

B. Proposed Clarifications

This proposal appropriately modifies and clarifies the

interpretation of the seventh prong. First, it clarifies that

concluding whether the seventh prong is met should be determined by

looking to the intent of the parties at the outset of contract

initiation.

Second, the new proposal also deletes language referring to

physical or regulatory factors being “outside of the control of the

parties.” Deleting this ambiguous language helps clarify that

parties having some influence over factors affecting their demand

for a nonfinancial commodity will not per se cause a contract to

fail the seventh prong.

In that vein, the proposal also notes that parties may take a

variety of factors into consideration when determining whether to

exercise volumetric optionality, so long as the intended purpose was

to address physical factors or regulatory requirements influencing

the demand for, or supply of, the commodity.

Prongs one through six of the test are also appropriately

crafted to ensure that the EVO does not undermine the forward

contract’s overall purpose. Prongs two and three help achieve those

purposes by requiring the predominant factor to be actual delivery,

and prohibiting the embedded optionality from being severed and

marketed separately from the overall agreement.

Prongs four and five also help deter the potential for abuse of

these contracts by requiring that the seller under the contract

intends to deliver, and the buyer intends to receive, the underlying

commodity.

This proposal should go a long way towards providing commercial

firms

[[Page 69078]]

adequate guidance, but I look forward to comments on whether it is

adequate enough.

Appendix 4–Concurring Statement of CFTC Commissioner Sharon Y. Bowen

This is a proposal that, I am concerned, will neither provide

the clarity industry is seeking regarding the treatment of embedded

volumetric options nor the safeguards that Congress intended when it

passed the Dodd-Frank Wall Street Reform and Customer Protection

Act.

I do not oppose the Commission’s trying to better tailor our

regulations to address concerns of end-users. In fact, I commend the

Chairman and my fellow Commissioners for trying to address the

issues that have arisen from our existing guidance and rules on

embedded volumetric options. After many meetings with stakeholders

and much analysis of this subject, I am convinced that the

Commission should address concerns that industry has raised

regarding the treatment of embedded volumetric options.

However, the proposed interpretation may not resolve the issues

industry has raised. Options, even physical options, have never been

interpreted by the Commission to be forward contracts. They lack the

central characteristic that is critical to being a forward contract

under the Commodity Exchange Act: A binding obligation to deliver at

some time in the future. The history on this is clear, if there is

no binding obligation to deliver, there is no forward contract.

The seventh factor was intended, essentially, as a “safe-

harbor” provision. Notwithstanding the fact there is no obligation

to make or take delivery for the optional portion of the specified

commodity, the seventh factor was designed to allow a party’s

transaction to receive the forward exclusion if that party can

demonstrate that it determined the specified, optional amount was

necessary based upon commercial and physical factors, and exercised

the option based upon those factors. In other words, this seventh

factor was designed to allow embedded volumetric options to receive

the forward contract exclusion treatment where their exercise was

driven largely by external commercial and physical factors central

to the party’s commercial business, but largely beyond the control

of the party. Through its conduct then, the party was demonstrating

its intent to be “bound” to exercise the option if its estimate,

based on the factors it used, proved to be accurate.

The Commission was trying to distinguish such a situation from a

situation where the party enters into the embedded volumetric option

intending to exercise the volumetric option based upon whether, at

the time of exercise, it still makes economic sense to use the

option. In other words, it was trying to distinguish a situation

where the motivation for exercising the option was primarily or

substantially based on price. In the latter case, the embedded

volumetric option is hard to distinguish, in usage, from any other

commodity option. There is no demonstration in the party’s course of

conduct that it intended to be “bound” to exercise the option at

all.

While this test is far from perfect, and I can see the

difficulty industry would have in administering it, the Commission

was clearly trying to find a rationale for allowing some volumetric

optionality that was consistent with the Commission’s historic

treatment of forward contracts, while avoiding completely erasing

the line between options and futures on the one hand, and cash and

forward contracts on the other.

This current proposal, however, in possibly broadening the

universe of options that would fit within the seventh factor, seems

to depart from that rationale, and in doing so, loses that vital

element of demonstrating the parties intended to be “bound” in

some sense to exercise the option and consequently that the option

was similar, in usage, to a forward contract. Without that, it is

not clear to me how such an option can be considered consistent with

a forward contract. If it cannot be considered at least similar to a

forward contract, I am not sure how a party would determine that

embedding such an option in a forward contract would not undermine

its nature as a forward contract and thus fail the first factor of

the seven-factor test.

There is nothing in the Commodity Exchange Act or Dodd-Frank

that contemplates options can be deemed forward contracts simply by

being associated with a forward contract. In fact, the opposite

seems true: Congress specifically determined that commodity options

are swaps and removed the Commission’s ability to provide exemptions

from the definition of swap.

Interestingly though, Congress did maintain the Commission’s

authority to determine how swaps that are commodity options should

be regulated since Congress did not repeal the Commission’s plenary

authority over options, including options that are swaps. It was

that plenary authority that the Commission utilized to exempt trade

options from most of the regulations applicable to swaps in April

2012. It is that authority that the Commission should use here to

address embedded volumetric options.

By seeking to broaden an exclusion for volumetric options

embedded in forward contracts, the proposed interpretation does try

to achieve a goal that industry apparently wants–they would like

these options to be outside the Commission’s jurisdiction rather

than just exempted from regulation. However, history has shown that

as the circle of exclusion widens for industry, too often the circle

of protection narrows for investors and consumers.

In 1993, one Commissioner cast the lone dissenting vote against

exempting over-the-counter energy derivatives from Commission

regulation. She argued that exempting energy derivatives from

regulation would set a dangerous precedent and would leave the

public unprotected. Today’s proposal seems to go farther. It

excludes embedded volumetric options from the Commission’s

authority. Whereas with an exemption, there is the ability to later

tailor it to fit the precise needs of the market and the public,

there is no turning back from an exclusion.

Congress said, quite clearly, that commodity options are swaps,

not forwards. Embedded volumetric options should be exempted as

options, not excluded as forwards. I know many in industry have

spoken for the need for further clarity regarding the regulation of

embedded volumetric options. I don’t know what clarity is achieved

by trying to call something what it is not. If it looks like an

option, is used like an option, and works like an option, it is most

likely, an option.

I think the objective of providing for clear regulatory

treatment of embedded volumetric options will be far easier to

implement, and far more complete, if done through fixing the trade

option exemption. Regardless, this proposal is the vehicle before

the Commission at present. I want us to get this interpretation

right, and therefore support getting public comment on these

changes. I do not believe we should contemplate such a significant

change to our jurisdiction without receiving the public’s views on

it first. I invite all interested stakeholders to respond to this

proposal and look forward to reviewing their comments.

[FR Doc. 2014-27285 Filed 11-19-14; 8:45 am]

BILLING CODE 6351-01-P; 8011-01-P

 

Last Updated: November 20, 2014