The Commodity Futures Trading Commission (CFTC) recently revised its interpretation of when forward contracts that relate to a nonfinancial commodity (Commodity) and include an embedded option to increase or decrease the volume of the Commodity to be sold and delivered or purchased and accepted under that contract (volumetric optionality) qualify for exclusion from the definition of “swap” under the Commodity Exchange Act, as amended (CEA), and the rules of the CFTC thereunder (Revised Interpretation).¹ The Revised Interpretation clarifies the CFTC’s original interpretation regarding the matter (Original Interpretation)² and relaxes the CFTC’s view of when such contracts are excluded from the definition of “swap.”³

Any company that is currently a party to, or that may in the future enter into, a supply or other agreement for the future, physical delivery of a Commodity, including natural gas, crude oil, LNGs or electricity, that gives a party to the agreement any volumetric optionality should review and understand the Revised Interpretation and take note of its usefulness in determining whether such agreement is a forward contract and not a swap.

Background

The definition of “swap” in the CEA provides that commodity options are “swaps” even if physically settled, but excludes by its terms “any contract of sale of a commodity for future delivery”⁴ and “any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled,” i.e., forward contracts, from being “swaps” under such definition (Exclusion). Parties to agreements, contracts and transactions relating to Commodities (Contracts), even ones with volumetric optionality, falling within the Exclusion need not comply with the swap-related provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), the swaps-related amendments to the CEA made by the Dodd-Frank Act and the CFTC’s rules thereunder as to such Contracts. Inclusion of volumetric optionality in a Contract otherwise qualifying as a forward contract can cause the Contract not to qualify for the Exclusion.

Under the Original Interpretation, a Contract with embedded volumetric optionality would qualify as a forward contract and, thus, fall within the Exclusion if each of seven elements was present. The seventh element of the Original Interpretation (Original Seventh Element) was “[t]he 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.”⁵ Parties to Contracts with embedded volumetric optionality have encountered significant difficulties when trying to determine if the Original Seventh Element was present with respect to such Contracts. Persons commenting to the CFTC on the Original Interpretation have reported that parties negotiating such Contracts have disagreed as to whether the Original Seventh Element was present with respect to such Contracts and that instances have occurred in which such a disagreement led one party to such a Contract treating the Contract as a forward contract falling within the Exclusion and the other party to the Contract treating the Contract as a swap. Such problems arose, no doubt in large measure, because companies and their advisers found it difficult to agree whether any future decision to exercise or not exercise a volumetric option in such a Contract would be based primarily on physical factors influencing the supply or demand of the Commodity covered by such Contract that would be outside the option holder’s control.

In addition, the Original Interpretation had also left market participants questioning if it applied both to puts and to calls. This question regarding the Original Interpretation and the problems with the Original Seventh Element noted above resulted in numerous calls for the CFTC to clarify the Original Interpretation.

The Revised Interpretation

The CFTC has heeded the calls for clarity and issued the Revised Interpretation, which is written to make clear that the Revised Interpretation applies both to puts and to calls and includes a significantly revised seventh element that is intended to be clearer than the Original Seventh Element. The seven elements of the Revised Interpretation that must be present with respect to a forward contract containing embedded volumetric optionality in order for such contract to qualify for the Exclusion are:

1. The embedded optionality does not undermine the overall nature of the Contract as a forward contract;

2. The predominant feature of the Contract is actual delivery;

3. The embedded optionality cannot be severed and marketed separately from the overall Contract in which it is embedded;

4. The seller of a Commodity underlying the Contract with embedded volumetric optionality intends, at the time it enters into the Contract, to deliver the underlying Commodity if the embedded volumetric optionality is exercised;

5. The buyer of a Commodity underlying the Contract with embedded volumetric optionality intends, at the time it enters into the Contract, to take delivery of the underlying 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 Contract, to address physical factors or regulatory requirements that reasonably influence demand for, or supply of, the Commodity.

The Revised Interpretation’s seventh element (Revised Seventh Element) improves the position of parties to Contracts with embedded volumetric optionality as it does not require those parties to predict the basis for their future actions regarding volumetric optionality in such Contract when assessing the applicability of the Revised Interpretation as did the Original Interpretation. In fact, the Revised Seventh Element has been revised so that it is much more likely to be present with respect to a Contract than was the case with the Original Seventh Element. 

However, the Revised Seventh Element includes the standard that the volumetric optionality in a Contract must primarily be intended to address physical factors or regulatory requirements that “reasonably influence demand for, or supply of,” the Commodity covered by such Contract and, thus, requires the parties to such Contract to make a judgment as to whether the particular physical factors or regulatory requirements that any instance of volumetric optionality is intended to address can reasonably influence the seller’s supply of the Commodity (if the seller holds such volumetric option) or the buyer’s demand for the Commodity (if the buyer holds such volumetric option). The Release provides no guidance as to what constitutes such a reasonable influence. Nevertheless, the Revised Seventh Element appears to make it easier for parties to Contracts that otherwise qualify as forward contracts to include volumetric optionality in such Contracts and still have such Contracts fall within the Exclusion and, thus, avoid the regulation of such Contracts as swaps.

Parties to a Contract with embedded volumetric optionality should always remember that the Revised Interpretation is applicable only to Contracts that would, without the embedded volumetric optionality, qualify as forward contracts and fall within the Exclusion. Even the presence of the Revised Interpretation’s seven elements will not cure a Contract’s failure to otherwise qualify as a forward contract.

CFTC Guidance for Application of the Revised Seventh Element

In addition to setting forth the Revised Interpretation, the CFTC has provided in the Release other helpful guidance for applying the Revised Seventh Element (Guidance). The Guidance includes the following points:

1. The Revised Seventh Element addresses the “primary reason” for including volumetric optionality in the forward contract, which “primary reason” the CFTC characterizes as giving commercial parties the flexibility to vary the amount of a Commodity delivered during a Contract’s life in response to uncertainty in the demand for or supply of the Commodity.

2. Embedded volumetric optionality must be included in a Contract primarily as a means of assuring a supply source or providing delivery flexibility in the face of uncertainty regarding the quantity of the Commodity that may be needed or produced in the future, consistent with the purposes of a forward contract. 

3. The focus of the Revised Seventh Element is the intent of the party to the Contract with the right to exercise the embedded volumetric optionality at the time of the Contract’s initiation. That intent may be ascertained by the relevant facts and circumstances surrounding such Contract, including the parties’ course of performance under the Contract. Commercial parties may rely on counterparty representations with respect to the intended purpose for embedding volumetric optionality in the Contract provided the parties do not have information that would cause a reasonable person to question the accuracy of the representations. Commercial parties are not required to conduct due diligence in order to rely on such representations.

4. The reference in the Revised Seventh Element to “physical factors” should be construed broadly to include any fact or circumstance that could reasonably influence supply or demand for the Commodity covered by a Contract. Such facts and circumstances include environmental factors, such as weather or location, relative operational considerations, such as the availability of transportation or technology, and broader social forces, such as demographics and geopolitics. 

5. Parties to a Contract having some influence over physical factors intended to be addressed by embedded volumetric optionality in such Contract, such as the scheduling of plant maintenance and plans for business expansion, would not be inconsistent with the satisfaction of the Revised Seventh Element provided that the optionality is included in a Contract at the initiation of that Contract primarily to address potential variability in supply of or demand for the Commodity, consistent with the purposes of a forward contract.

6. If embedded volumetric optionality is included in a Contract at initiation primarily to address concerns with the risk of price volatility (e.g., to protect against increases or decreases in the cash market price for the Commodity covered by such Contract), the Revised Seventh Element would not be present as to such Contract unless the volumetric optionality was included in such Contract to address price volatility as a result of an applicable regulatory requirement, including formal or informal guidance received from a public utility commission or other similar governing body.

7. Although the CFTC recognizes that price is likely to be a consideration when entering into any Contract, including a forward contract, to ensure that the overall nature of a Contract as a forward contract is not undermined by including volumetric optionality, the embedded volumetric optionality must be primarily intended to be a means for securing a supply source in the face of uncertainty arising from physical factors or regulatory requirements (such as an obligation to ensure system reliability) regarding the volume of the Commodity to be needed or produced. 

8. Commercial parties may choose to rely either on their good faith characterization of existing Contracts as excluded forward contracts (even though the Contracts contained embedded volumetric optionality)⁶ or trade options⁷ or may re-characterize their Contracts in accordance with the Revised Interpretation.

9. With respect to Contracts in which electric utilities have the right to interrupt or curtail service to a customer to support system reliability, demand response agreements, even if not specifically mandated by an electricity system operator, may be properly characterized as the product of regulatory requirements.

Parties determining if the Revised Seventh Element is present with respect to any Contract should consider the Guidance carefully when making that determination, but may need to do some interpretation of their own when applying the Guidance. For example, the point of the Guidance described above in paragraph 7 indicates that volumetric optionality in a Contract is acceptable if the primary intent for inclusion in the Contract is to provide a means of “securing a supply source” in the face of physical factors or regulatory requirements regarding the volume of the Commodity to be needed or produced. Although this point of the Guidance could be seen as suggesting that the Revised Interpretation only applies if the volumetric optionality is included in a Contract so that a buyer may secure a supply source and does not permit a seller to address the uncertainties of its future production, such interpretation conflicts with the specific provisions of the Revised Interpretation and with the reference made in this point of the Guidance to the volume of the Commodity to be produced. Consequently, it appears that the CFTC did not intend the Guidance to narrow the Revised Interpretation. 

Similarly, the statement in the point of the Guidance described above in paragraph 4 that the phrase “physical factors” in the Revised Seventh Element should be interpreted broadly does appear to give some latitude in determining whether the physical factors that the parties to a Contract have in mind when including volumetric optionality in such Contract are factors that “reasonably influence” supply or demand of the Commodity covered by such Contract. Contract parties will have to interpret how far that latitude extends and whether the physical factors the Contract parties have in mind when entering into such Contract meet the “reasonably influence” standard of the Revised Seventh Element.

Practical Considerations

• Parties negotiating a Contract intended to fit within the Revised Interpretation should be certain that such Contract will otherwise qualify as a forward contract⁸ and that the predominant feature of the Contract is physical delivery of the Commodity under the Contract. Volumetric optionality embedded in such a Contract should be included to address only physical factors or regulatory requirements reasonably influencing demand for, or supply of, the Commodity, not to address the seller’s or the buyer’s price risk.

• Parties negotiating a Contract intended to fit within the Revised Interpretation should not give a party to the Contract the ability to reduce the amount of the Commodity to be sold and delivered or purchased and accepted under the Contract to zero. To ensure the overall nature of the Contract is that of a forward contract, some volumes covered by the Contract must be firm. A Contract providing for total optionality on the part of the seller or the buyer (or both) will not have the first element of the Revised Interpretation present. Moreover, although the CFTC has not addressed the matter in the Original Interpretation or the Revised Interpretation, an attempt to capture the essential benefit of total optionality by having each party be subject to a firm commitment to sell or purchase a small amount of the Commodity under a Contract should be avoided. The CFTC is likely to view such an expedient as making the Contract one as to which the optionality negates the essential nature of the Contract as a forward contract.

• The provisions providing volumetric options in Contracts should be carefully drafted. For example, the point in the Guidance described above in paragraph 5 appears to make clear the shutdown of a plant producing, processing or using a Commodity covered by a Contract for purposes of conducting plant maintenance will not be the type of physical factor contemplated by the Revised Seventh Element that would be deemed to reasonably influence supply or demand for the Commodity. As a result, a stand-alone option of a seller or buyer to curtail deliveries of volumes of a Commodity in order to address plant maintenance should not be included in a Contract intended to fit within the Revised Interpretation. A seller or a buyer may want to consider including in a volumetric option provision a secondary right to curtail delivery or acceptance of volumes of a Commodity to address plant maintenance, so long as the parties to the Contract in which the provision appears can demonstrate that the primary reason for which the volumetric option provision is included in the Contract is to address one or more other physical factors or regulatory requirements reasonably influencing, as appropriate, the supply of, or demand for, the Commodity.

• Parties to a Contract with embedded volumetric optionality that want such Contract to fit within the Revised Interpretation will want to include representations that each instance of volumetric optionality in the Contract is primarily intended to address physical factors or the regulatory requirements reasonably influencing, as appropriate, the supply of, or demand for, the Commodity covered by the Contract. Provisions providing for volumetric optionality in a Contract for the sale and purchase of a commodity most often specify the factors allowing the option holder to exercise its volumetric option. Any representation by the option holder relating to such triggering factors included in a Contract will have value for purposes of establishing such Contract fits within the Revised Interpretation only if the option holder can conclude that the triggering factors reasonably influence, as appropriate, supply of, or demand for, the Commodity.

• Although the point of the Guidance described above in paragraph 3 notes that a party to a Contract does not have to perform due diligence regarding its counterparty’s intent in including volumetric optionality in such Contract when determining whether the Revised Seventh Element is present with respect to such Contract, parties to such Contracts must be alert to red flags or other warning signs that the representation may be inaccurate and assess the accuracy of such representation in light of all such red flags and warning signs and all available information.

• Care should be taken when identifying the primary intent of a party to a Contract for the inclusion of volumetric optionality in such Contract and making representations in such Contract as to such intent. The parties to such Contract should be confident they can demonstrate to the CFTC that such optionality is intended by them to address particular physical factors or regulatory requirements that reasonably influence supply or demand of the particular Commodity to which such Contract relates.

• Notwithstanding the point of Guidance described above in paragraph 5 allowing an option holder to have some control over a physical factor that the volumetric optionality is intended to address, if the option holder has substantial control over the primary factor that the volumetric optionality is intended to address, the Contract would likely not fit within the Revised Interpretation. The analysis with respect to such physical factors may prove to be more nuanced than expected. Consider, for example, a buyer who insists on having the contractual option to reduce the volume of natural gas it will acquire and accept delivery of under a Contract in order to address a potential lack of storage capacity for that natural gas at the time of a scheduled delivery under such Contract. The seller and buyer should be comfortable that storage capacity is a physical factor that reasonably influences the buyer’s demand for natural gas for purposes of the Revised Seventh Element. However, having such comfort would likely not be justified on either party’s part unless the storage facility used by the buyer to store the Commodity delivered under such Contract is controlled by a third party unrelated to the buyer. If the buyer insists on including the optionality in such Contract knowing that its storage capacity issue may be created solely by the buyer purchasing volumes of natural gas on the spot market to capture the benefit of a spot market price that is lower than the Contract’s price, the intent of the buyer for the optionality may well not be of the type contemplated by the Revised Seventh Element. 

• When determining if a Contract with embedded volumetric optionality fits within the Revised Interpretation, each instance of volumetric optionality in such Contract should be assessed separately. No CFTC guidance appears to contemplate a particular instance of volumetric optionality in a Contract being considered as an agreement or transaction separate from the balance of the Contract for purposes of the swap laws and rules. As a result, it appears as if the benefit of the Revised Interpretation will be unavailable if any volumetric option in a Contract causes such Contract to fail to qualify as a forward contract that does not fit within the Revised Interpretation. Companies should remember, however, that the Revised Interpretation is not an exclusive test of whether a Contract with embedded volumetric optionality qualifies as a forward contract that falls within the Exclusion.

• Parties with existing Contracts with embedded volumetric optionality that are currently treating such Contracts as swaps should reassess such Contracts in light of the Revised Interpretation. One or more of such Contracts may fit within the Revised Interpretation and fall within the Exclusion, and, thus, no longer need to be characterized as swaps. Such a re-characterization would allow the parties to any re-characterized Contract to avoid the burdens and costs of compliance with the swap laws and rules with respect to such Contract.

_{1. See Forward Contracts With Embedded Volumetric Optionality, 80 Fed. Reg. 28239 (May 18, 2015), available at http://www.gpo.gov/fdsys/pkg/FR-2015-05-18/pdf/2015-11946.pdf (Release). The Release was issued jointly by the CFTC and the Securities and Exchange Commission (SEC), but the Revised Interpretation, which became effective on May 18, 2015, is an interpretation of the CFTC.}

_{2. The CFTC included the Original Interpretation in its joint release with the SEC relating to the further definition of a number of terms, including “swap.” See Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 Fed. Reg. 48208 (Aug. 13, 2012), available at http://www.gpo.gov/fdsys/pkg/FR-2012-08-13/pdf/2012-18003.pdf (Products Release).}

_{3. The term “swap” is defined in CEA §1a(47), 7 U.S.C. §1a(47), and further defined in 17 C.F.R. §1.3(xxx).}

_{4. The definition of “future delivery” excludes “any sale of any cash commodity for deferred shipment or delivery.” CEA §1a(27), 7 U.S.C. §1a(27). The CFTC considers a “cash commodity” to be a physical or actual commodity distinguished from a futures contract. See CFTC Glossary, available at http://www.cftc.gov/ConsumerProtection/EducationCenter/CFTCGlossary/index.htm#C.}

_{5. See Products Release at 48238.}

_{6. In so noting, the CFTC affirms that the Revised Interpretation is not an exclusive test of whether a Contract is a forward contract for purposes of the Exclusion, but is in the nature of a safe harbor.}

_{7. Commodity option transactions qualifying as “trade options” are not subject to all of the regulatory requirements to which other swaps are subject. See 17 C.F.R. §§32.1-32.5 for the rules relating to trade options.}

_{8. Among other things, companies desiring to have Contracts qualify as forward contracts should avoid including in such Contracts terms that provide for the financial settlement of obligations under such Contracts.}