In November 2014, the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) proposed a clarification of their previously issued interpretation and seven-part test concerning the exclusion of forward contracts with embedded volumetric optionality from the definition of “swap.” After a review of all comments received, on May 12, 2015, the CFTC and SEC jointly issued the CFTC’s final interpretation. The CFTC’s interpretation includes the following clarifications:
Fourth and Fifth Elements
The CFTC is modifying the fourth and fifth elements of the seven-part test to clarify that it applies to forward contracts with embedded volumetric optionality in the form of both puts and calls. In response to commenters, the CFTC also clarified that bandwidth (a.k.a. “swing”) contracts, which provide for delivery of a quantity of a nonfinancial commodity within a certain minimum and maximum range, are not precluded from falling within the forward contract exclusion.
The CFTC is modifying the seventh element to provide that the embedded volumetric optionality must be “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.” Thus, the focus of the seventh element is on the intent of the party with the right to exercise the embedded volumetric optionality at the time the parties enter into the contract.
According to the CFTC, commercial parties are not required to conduct due diligence in order to ascertain the intent of another party to the contract. However, if the embedded volumetric optionality is intended – at the time the contract is initiated – primarily to address concerns about price, the seventh element would not be satisfied absent an applicable regulatory requirement, including guidance received from a public utility commission or similar body, to obtain or provide the lowest price.
The CFTC clarified that the reference to “physical factors” in the seventh element should be construed broadly to include any fact or circumstance that could reasonably influence the parties’ supply of or demand for the nonfinancial commodity under the contract, including environmental factors, relevant “operational considerations,” and broader social forces, such as changes in demographics or geopolitics.
Providing Greater Flexibility for Commercial Users
This interpretation is designed to guide the manufacturing, agriculture and energy sectors on how to maintain the forward nature of their contracts (actual delivery of the commodity) while allowing the flexibility needed by these companies and utilities to exercise the option to add or remove volume to the underlying quantity of product to be delivered in response to market demand.
For example, this interpretation will be very helpful to electric utilities. The CFTC recognized that, given that a key function of an electricity system operator is to ensure grid reliability, demand response agreements (in which the utility has the right to interrupt or curtail service to a customer to support system reliability) may be characterized as the product of regulatory requirements, and therefore meet the requirements of the seventh element.
Finally, in response to commenters, the CFTC clarified that commercial parties may choose either to rely on their good faith characterization of an existing contract or to recharacterize it in accordance with the CFTC’s interpretation.
Commissioner Sharon Bowen, who proposed an additional exemption to the CFTC’s proposed trade option rule that would exempt a forward contract with “volumetric variability” and a new test for determining when peaking supply contracts are commodity options, stated that she supports this final interpretation. However, she called for “greater legal certainty” in the definitions of options and forward contracts under the Commodity Exchange Act.
The final interpretation will be effective upon publication in the Federal Register. If you would like to learn more about the CFTC’s interpretation, please contact a member of Schiff Hardin’s Financial Markets and Products Practice Group or its Energy and Public Utilities Practice Group.