On August 13, 2012, the Commodity Futures Trading Commission (“CFTC”) and the Securities Exchange Commission (“SEC”) published an order [PDF] revising in a number of respects the definition of “swap” the commissions had adopted on July 10, 2012, as part of their attempts to implement the Dodd-Frank Act. Of particular interest to the energy industry, the commissions modified their earlier conclusion that contracts providing for the payment of volumetric rates were swaps rather than forward contracts.
Under Dodd-Frank, swaps are subject to a new regulatory framework implemented by the CFTC and the SEC. Forward contracts, which generally provide for physical delivery of nonfinancial commodities such as natural gas and electricity, are not swaps and are not, therefore, covered by the new regulatory requirements. On July 10, the CFTC and SEC jointly issued an order defining “swap” within the meaning of Dodd-Frank. In that order, the commissions concluded that contracts for the use of a facility could be “commodity options subject to the swap definition” if they provided for the payment of usage fees in addition to reservation fees. Under this view, standard electric and natural gas transmission, transportation, supply, and storage contracts could qualify as swaps and be subject to regulation by the commissions.
The August 13 order seems to reverse that conclusion. The commissions state that they will examine all facts and circumstances to determine whether contracts are swaps or forwards. With respect to contracts that provide for volumetric optionality, the contract will be a considered a forward contract that is exempt from Dodd-Frank regulation if it meets a seven-part test (77 Fed. Reg. at 48238):
- The embedded optionality does not undermine the overall nature of the agreement, as a forward contract;
- The predominant feature of the agreement is actual delivery;
- The embedded optionality cannot be severed and marketed separately from the overall agreement in which it is embedded;
- The seller of a nonfinancial commodity underlying the agreement with embedded volumetric optionality intends, at the time it enters into the agreement, to deliver the underlying nonfinancial commodity if the optionality is exercised;
- The buyer of a nonfinancial commodity underlying the agreement with embedded volumetric optionality intends, at the time it enters into the agreement to take delivery of the underlying nonfinancial commodity if it exercises the embedded volumetric optionality;
- Both parties are commercial parties (the August 13 order makes clear that this requires both parties to be active participants in the energy industry, rather than mere financial participants);
- 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 August 13 order indicates that it is highly likely that full requirements and output contracts will be forward contracts. In addition, contracts for electric transmission or natural gas transportation and storage capacity are also likely to qualify as forwards.
The commissions seek additional comment on the volumetric optionality provisions of the August 13 order. In particular, they seek input regarding the seven factors to be used to determine if a contract with volumetric optionality is a forward contract. Comments must be filed no later than October 12, 2012.