On November 3, 2014, the Commodity Futures Trading Commission (CFTC), along with the Securities and Exchange Commission (SEC), proposed a clarification of its previously issued interpretation concerning the exclusion of forward contracts with embedded volumetric optionality from the “swap” and “future delivery” definitions.  The CFTC seeks to clarify the seven elements previously provided as guidance to market participants analyzing whether a contract with embedded volumetric optionality is a swap or a forward.  Specifically, the proposed clarification would address concerns raised by utilities and commercial market participants regarding the application of the fourth, fifth, and seventh elements of the interpretive test.

The utilities and commercial market participants were concerned that the test may capture certain supply contracts with embedded volumetric optionality used in purchasing programs within the swap definition.  As explained below, the adoption of this proposal would modify some of the elements, including the crucial seventh element, and clarify the scope of transactions that would qualify for the forward contract exclusion.  The CFTC has invited public comments on this interpretive proposal and, based on the Commissioners’ comments, there is still room for movement either way on the final interpretation. The text of the Federal Register notice can be found here.

Background

The CFTC and the SEC originally drafted interpretive guidance as part of the Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping (the Products Release) wherein the CFTC provided an interpretation with respect to forward contracts that allowed variations of the volume of the delivery amount (the Embedded Volumetric Optionality Test).   According to the Products Release, the seven elements of the Embedded Volumetric Optionality Test for the forward contract exclusion from the swap and future delivery definitions are met when:

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 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 it exercises the embedded volumetric optionality;

6) Both parties are commercial parties;

7) 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.

Proposed Interpretation Clarifies Crucial Elements  

The CFTC held a public roundtable on March 5, 2014, to hear complaints, comments and proposals to address the ambiguities in the seven factors.  As a result of the discussions during that roundtable and comment letters received after it, the CFTC and SEC propose clarifications to elements four, five and seven of the test to respond to industry concerns.

The CFTC has proposed that the fourth and fifth elements would be slightly modified to clarify that the test applies to embedded volumetric optionality in the form of both puts and calls.

However, the CFTC recognized that the application of the seventh element created the greatest problems for the industry.  There was confusion regarding the breadth of the “physical factors” that would be “outside the control of the parties” when drafting and reviewing these contracts.  Some counterparties would disagree during contract negotiations on whether a particular factor was outside the party’s control or not.  This confusion manifested itself into parties entering master agreements that “agreed to disagree” on whether a transaction was a forward and excluded from the swap and future delivery definition.   Commissioner Wetjen noted in his opening statement at the November 3rdmeeting that this confusion was having the unintended consequence of distorting swap reporting data to the Commission.  This “agree to disagree” reaction by counterparties made it such that some transactions might be called a swap by one party and therefore reported, but the other party might believe it to be a forward and not report it.

Additionally, energy market participants noted that they may not always know at the time the contract was executed what particular reasons might create the need to exercise the embedded volumetric optionality, and, therefore, they were concerned their intent at the time of exercise or non-exercise of the option may affect their analysis under the seventh factor.

To address these concerns the CFTC’s interpretive proposal modifies the seventh element to read as follows:

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.

This new language is the CFTC’s attempt to address the following issues:

1) That the embedded volumetric optionality must be intended at the time of execution of the agreement, contract or transaction to address any physical factors or regulatory requirements that reasonably influences supply or demand;

2) That the parties have some degree of influence or control over physical or regulatory requirement factors affecting supply and demand as opposed to these factors being completely “outside their control”;

3) That the “physical factors” would be construed broadly to include any fact or circumstance that would reasonably influence the parties supply or demand issues – including environmental factors, “operational considerations,” and broader social forces such as demographics or geopolitics; and

4) That electric demand response agreements would meet the regulatory requirement within the meaning of the seventh element.

The CFTC stated that the intent of the Embedded Volumetric Optionality Test was to ensure that the primary purpose of including embedded volumetric optionality within the contract was to provide flexibility with respect to the amount of the commodity delivered when parties are uncertain regarding the quantity that would be needed in the future.

CFTC Requests Comment and Poses Specific Questions

While the CFTC has offered this interpretative proposal to attempt to clarify the Embedded Volumetric Optionality Test, the Commissioners comments during the open meeting and published with the interpretive proposal indicate that they may still be somewhat at odds on if this interpretive proposal goes far enough to address concerns, or goes too far for the CFTC’s comfort.

As a part of the proposal and request for comment, the CFTC posed three questions for public  comment:

1) The mechanism of relief provided by the Interim Final Rule for Commodity Options (the Trade Option) and whether it provides clearer relief than the proposed interpretation on this issue;

2) Whether the lack of clarity on the seventh element of the Embedded Volumetric Optionality Test has led to costs to end-users; and

3) What factors should the CFTC consider to determine if the proposed modifications and clarifications are appropriate under the forward contract exclusion, do the proposed modifications and clarifications provide sufficient clarity on how these contracts satisfy all of the elements, particularly the first and second elements, and if there are reasons that this further relief would not be in the public’s interest.

The public comment period for the CFTC interpretive proposal ends on December 22, 2015.