2015-11946

Federal Register, Volume 80 Issue 95 (Monday, May 18, 2015)

[Federal Register Volume 80, Number 95 (Monday, May 18, 2015)]

[Notices]

[Pages 28239-28244]

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

[FR Doc No: 2015-11946]

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COMMODITY FUTURES TRADING COMMISSION

RIN 3038-AE24

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-74936; File No. S7-16-11]

RIN 3235-AK65

Forward Contracts With Embedded Volumetric Optionality

AGENCY: Commodity Futures Trading Commission; Securities and Exchange

Commission.

ACTION: Final interpretation.

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

Street

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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 clarification of its interpretation

concerning forward contracts with embedded volumetric optionality.

DATES: This interpretation is effective on May 18, 2015.

FOR FURTHER INFORMATION CONTACT: CFTC: Elise Pallais, Counsel, (202)

418-5577, [email protected]; Mark Fajfar, Assistant General Counsel,

(202) 418-6636, [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 options \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\

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\1\ See 77 FR 48207, 48238-42 (Aug. 13, 2012). As described in

the Products Release, the interpretation included the following

seven elements:

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; and

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.

\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'') (emphasis added).

\3\ See 77 FR at 48238-42 & n.335. As explained in the Products

Release, the CFTC interprets the exclusions in CEA sections

1a(47)(B)(ii) and 1a(27) as coextensive and thus requiring a

consistent interpretation. See id. at 48227-8. See also id. at

48227-36 (discussing 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 * * *''). CEA section 1a(47)(A)(i) does not

differentiate between financially- and physically-settled options.

Certain physically-settled options, termed ``trade options,'' are

nevertheless exempt from most requirements applicable to swaps. See

17 CFR 32.3. Additionally, the CFTC is proposing to amend its trade

option exemption to further reduce the reporting and recordkeeping

requirements applicable to certain commercial end users. See Trade

Options, 80 FR 26200 (May 7, 2015).

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In response to requests from market participants,\6\ the CFTC

proposed in November 2014 to clarify its interpretation of when an

agreement, contract, or transaction with embedded volumetric

optionality would be considered a forward contract.\7\ In particular,

the CFTC proposed to (a) modify the fourth and fifth elements of its

interpretation to clarify that the interpretation applies to embedded

volumetric optionality in the form of both puts and calls \8\ and (b)

modify the seventh element to clarify that the embedded volumetric

optionality must be primarily intended, at the time 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.\9\ The CFTC requested

comment on all aspects of its proposal.\10\

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\6\ The Products Release included a request for comment on the

CFTC's interpretation regarding forward contracts with embedded

volumetric optionality. See 77 FR at 48241-42. CFTC staff also

solicited comments in connection with a public roundtable on 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. In general,

commenters asserted that uncertainty with regard to the CFTC's

interpretation, particularly the seventh element, has led to

confusion over whether to characterize certain transactions as

excluded forward contracts with embedded volumetric optionality or

regulated trade options.

\7\ Forward Contracts With Embedded Volumetric Optionality, 79

FR 69073 (Nov. 20, 2014) (the ``Proposed Interpretation''). Section

712(d)(4) of the Dodd-Frank Act 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 requires this

interpretation, which was originally included in the Products

Release, to be issued jointly by the CFTC and the SEC, it is an

interpretation solely of the CFTC and does 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.

\8\ Id. at 69074.

\9\ Id. at 69074-76.

\10\ See id. at 69076. The CFTC also requested comment in

response to specific questions relating to its proposal. Id. The

comment file, which includes 22 unique comments and one (1) ex parte

communication, is available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1541. Commenters include American

Gas Association; American Petroleum Institute; American Public Power

Association, Edison Electric Institute, Electric Power Supply

Association, Large Public Power Council, and National Rural Electric

Cooperative Association; Americans for Financial Reform; Barnard,

Chris; Better Markets Inc.; Business Council for Sustainable Energy;

Coalition for Derivatives End-Users; Coalition of Physical Energy

Companies; Cogen Technologies Linden Venture LP; Commercial Energy

Working Group and Commodity Markets Council; Dairy Farmers of

America; EDF Trading North America LLC; Federal Energy Regulatory

Commission staff; Fig, Willem; International Energy Credit

Association; International Swaps and Derivatives Association Inc.;

National Association of Manufacturers; National Corn Growers

Association and Natural Gas Supply Association; National Energy

Marketers Association; Public Citizen; and Southern Company Services

Inc., acting on behalf of and as agent for Alabama Power Co.,

Georgia Power Co., Gulf Power Co., Mississippi Power Co., and

Southern Power Co. None of the commenters requested any revisions to

SEC rules or regulations (or interpretations thereof), but rather

addressed issues relating solely to the CFTC's interpretation.

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II. Overview

After a careful review of the comments received, the CFTC has

determined to finalize its interpretation as proposed with some

additional clarifications. Accordingly, 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:

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.

As stated in the Proposed Interpretation, the first six elements of

this interpretation are largely unchanged from the Products

Release.\11\ Among them, only the fourth and fifth elements have been

modified, as proposed, to clarify that the CFTC's interpretation

applies to embedded volumetric optionality in the form of both puts and

calls.\12\ Accordingly, the CFTC's discussion of these six elements in

the Products Release remains relevant and applicable.\13\ The seventh

element of the interpretation is discussed further below.

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\11\ See 77 FR at 48238.

\12\ 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 at 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).

\13\ See 77 FR at 48238-39.

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As a general matter, the CFTC clarifies that its interpretation

with respect to forward contracts with embedded volumetric optionality

should not be read to alter or expand the historic interpretation of

the forward contract exclusion. As the first two elements affirm, the

interpretation presupposes the existence of an underlying forward

contract, as determined by applying the historic interpretation of the

forward contract exclusion.\14\ The CFTC's interpretation, as provided

herein, merely identifies the circumstances under which volumetric

optionality embedded in such a forward contract would not operate to

take the contract outside the forward contract exclusion.\15\ As

explained in the Products Release, the historic interpretation of the

forward contract exclusion remains relevant and applicable.\16\

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\14\ See id. at 48227-36.

\15\ The CFTC's interpretation only addresses when a forward

contract with embedded volumetric optionality would be excluded from

the swap or future delivery definitions in the CEA; it does not

address whether a contract would otherwise fall within the swap

definition. In other words, a contract that does not meet one or

more elements of the CFTC's interpretation may or may not be a swap

depending on the characteristics of the contract. See, e.g., id. at

48246-52 (discussing application of the swap definition to consumer

and commercial agreements).

\16\ See, e.g., id. at 48228.

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In response to commenters, the CFTC clarifies that the fourth and

fifth elements of the interpretation do not preclude bandwidth (a.k.a.

``swing'') contracts, which provide for delivery of a nonfinancial

commodity within a certain minimum and maximum range, from falling

within the forward contract exclusion from the swap and future delivery

definitions.\17\ As indicated in the Products Release, the fourth and

fifth elements merely require that the intent to make or take delivery

(as applicable) required of the underlying forward contract extends to

the embedded volumetric optionality, such that both parties to the

contract intend to make or take delivery (as applicable) of the

nonfinancial commodity under the contract if the embedded volumetric

optionality is exercised.\18\ The embedded volumetric optionality may

therefore operate to increase and/or decrease the quantity delivered

under the underlying forward contract and still not take the contract

out of the forward exclusion provided that all elements of the CFTC's

interpretation, as provided herein, are satisfied.

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\17\ See Letter from Coalition of Physical Energy Companies

(Dec. 22, 2014) at 4; Letter from Commercial Energy Working Group

and Commodity Markets Council (Dec. 22, 2014) at 3-4; Letter from

EDF Trading North America LLC (``EDFTNA'') (Dec. 22, 2014) at 15-17;

Letter from International Energy Credit Association (``IECA'') (Dec.

22, 2014) at 4-5; Letter from International Swaps and Derivatives

Association Inc. (Dec. 22, 2014) at 3 (each requesting clarification

that the fourth and fifth elements permit both increases and

decreases in volume).

\18\ See 77 FR at 48239 (``The fourth and fifth elements are

designed to ensure that both parties intend to make or take delivery

(as applicable), subject to the relevant physical factors or

regulatory requirements, which may lead the parties to deliver more

or less than originally intended.'') (emphasis added).

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III. The Seventh Element

As stated in the Proposed Interpretation, the seventh element

addresses the primary reason for including embedded volumetric

optionality in a forward contract.\19\ Embedded volumetric optionality

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.\20\ The seventh element ensures that this purpose,

consistent with the historical interpretation of a forward

contract,\21\ 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.\22\

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\19\ See 79 FR at 69074-75.

\20\ See, e.g., Letter from the Commodity Markets Council, the

National Corn Growers Association, and the Natural Gas Supply

Association (``CMC/NCGA/NGA'') (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.'').

\21\ See 77 FR 48228 (describing a forward contract as a

``commercial merchandising transaction'' in which delivery is

delayed for ``commercial convenience or necessity'').

\22\ See 77 FR at 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 CMC/

NCGA/NGA (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 (stating

that ``[a]lthough the amounts that can be taken on delivery may

vary, the primary intent of the contracts is not to provide price

protection'').

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As indicated in the Proposed Interpretation, the focus of the

seventh element is the intent of the party with the right to exercise

the embedded volumetric optionality at the time of contract

initiation.\23\ In line with the CFTC's historical interpretation of

the forward contract exclusion, as discussed in the Products Release,

such intent may be ascertained by the relevant facts and circumstances

surrounding the contract, including the parties' course of performance

thereunder.\24\ Nevertheless, commercial parties may rely on

counterparty representations with respect to the intended purpose for

embedding volumetric optionality in the contract provided they do not

have information that would cause a reasonable person to question the

accuracy of the representation. In response to commenters, the CFTC

clarifies that commercial parties are not required to conduct due

diligence in order to rely on such representations.\25\

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\23\ 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. See also Letter from EDFTNA (Dec. 22, 2014) at 20

(requesting further clarification that the seventh element only

addresses the intent of the party with the right to exercise the

embedded volumetric optionality.)

\24\ See 77 FR 48228 (``In assessing the parties' expectations

or intent regarding delivery, the CFTC consistently has applied a

`facts and circumstances' test.''). For example, if one party has an

option to settle a contract financially based upon a value change in

an underlying cash market, then the contract may be a swap. See id.

at 48241 n. 370. See also Letter from ONEOK, Inc. (July 22, 2011) at

6 (acknowledging that ``[t]he 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.'').

\25\ See Letter from EDFTNA (Dec. 22, 2014) at 22-23 (arguing

that requiring counterparties to conduct due diligence in order to

ensure that facts suggesting an alternate purpose for the embedded

volumetric optionality are not present would be ``infeasible'' and

may undercut the utility of the Proposed Interpretation).

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The CFTC clarifies that the seventh element's reference to

``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.\26\ The

CFTC further clarifies that the parties' having some influence over

such physical factors (e.g., the scheduling of plant maintenance, plans

for business expansion) would not be inconsistent with the seventh

element, 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, consistent with the purposes of a forward contract.

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\26\ 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 at 48239 n.345.

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The CFTC reiterates, however, that if the embedded volumetric

optionality is primarily intended, at contract initiation, to address

concerns about price risk (e.g., to protect against increases or

decreases in the cash market price), the seventh element would not be

satisfied absent an applicable regulatory requirement, including

guidance, whether formal or informal, received from a public utility

commission or other similar governing body, to obtain or provide the

lowest price (e.g., the buyer is an energy company regulated on a cost-

of-service basis).\27\ The CFTC recognizes that, as commenters have

pointed out, price is likely to be a consideration when entering into

any contract, including a forward contract.\28\ However, to ensure

that, as required by the first element, the overall nature of the

contract as a forward is not undermined,\29\ the embedded volumetric

optionality must, as stated above, be primarily intended as a means of

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 nonfinancial

commodity to be needed or produced.\30\

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\27\ The CFTC confirms that, as stated in the Proposed

Interpretation and 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 at 48238 n.340.

\28\ See 77 FR at 48228 (``The primary purpose of a forward

contract is to transfer ownership of the commodity and not to

transfer solely its price risk.'') (emphasis added). See also Letter

from American Gas Association (``AGA'') (Dec. 22, 2014) at 8-10;

Letter from Coalition for Derivatives End-Users (Dec. 22, 2014) at

6; Letter from American Public Power Association, Edison Electric

Institute, Electric Power Supply Association, Large Public Power

Council, and National Rural Electric Cooperative Association

(``Joint Associations'') (Dec. 22, 2014) at 4-5; Letter from

Southern Company Services Inc., acting on behalf of and as agent for

Alabama Power Co., Georgia Power Co., Gulf Power Co., Mississippi

Power Co., and Southern Power Co. (Dec. 22, 2014) at 2-3.

\29\ See 77 FR at 48227-36.

\30\ See 1985 CFTC OGC Interpretation, 50 FR at 39658. But see

supra note 23; Letter from National Corn Growers Association and

Natural Gas Supply Association (Dec. 22, 2014) (recognizing that

price concerns are acceptable ``if they arise subsequent to

execution or are motivated by an applicable regulatory

requirement'').

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Additionally, as stated in the Proposed Interpretation, 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.\31\ The CFTC

clarifies 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.\32\

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\31\ 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.

\32\ The CFTC further clarifies that its interpretations

regarding full requirements and output contracts, as provided in the

Products Release, remain relevant and unaffected by the discussion

herein. See 77 FR at 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.

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Finally, in response to requests from commenters, the CFTC

clarifies that commercial parties may choose to either rely on their

good faith characterization of an existing contract (e.g., as an

excluded forward contract with embedded volumetric optionality or an

exempt trade option) and or recharacterize it in accordance with this

final interpretation.\33\

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\33\ Letter from AGA (Dec. 22, 2104) at 12, 19 (requesting

relief for market participants who reported transactions as trade

options that, following adoption of the Proposed Interpretation,

they would consider excluded forwards); Letter from EDFTNA (Dec. 22,

2014) at 5-7 (arguing that reassessment of the legal character of an

existing contract is impractical) Letter from IECA (Dec. 22, 2014)

at 3 (arguing that requiring parties to reclassify their existing

contracts following adoption of the Proposed Interpretation would be

unduly burdensome); Letter from Joint Associations (Dec. 22, 2014)

at 11 (requesting that the CFTC allow counterparties to reclassify

their transactions following adoption of the Proposed

Interpretation).

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[[Page 28243]]

The CFTC believes that these modifications are appropriately

measured to clarify the meaning of certain language in the seventh

element and should not be construed as a shift in the CFTC's

longstanding precedent on the difference between forward contracts and

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options.

By the Securities and Exchange Commission.

Dated: May 12, 2015.

Brent J. Fields,

Secretary.

Issued in Washington, DC, on May 12, 2015, 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 Commissioner's Statement

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 Support of CFTC Chairman Timothy G. Massad

I support the staff's recommendations to finalize a proposal we

made in November regarding contracts with embedded volumetric

optionality--a contractual right to receive more or less of a

commodity at the negotiated contract price.

As I said in my statement on the proposal, with reforms as

significant as these, it is inevitable that there will be a need for

some minor adjustments. And that is what we are doing. The changes

we are proposing today help ensure that as we regulate the potential

for excessive risks in these markets, we make sure that the

commercial businesses--whether they are farmers, ranchers,

manufacturers or others--that rely on these markets to hedge routine

risks can continue to do so efficiently and effectively.

Specifically, we proposed to clarify when a contract with

embedded volumetric optionality will be excluded from being

considered a swap. We received a number of comments on this and we

have incorporated some of the concerns in the final clarification.

Today, following action by the SEC last week, we are posting to the

Federal Register the final interpretation. By clarifying how these

agreements will be treated for regulatory purposes, the

interpretation should make it easier for commercial companies to

continue to use these types of contracts in their daily operations.

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 finalizing 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.

Appendix 3--Concurring Statement of CFTC Commissioner Sharon Y. Bowen

Today we are approving a final interpretation regarding forward

contracts with embedded optionality. This interpretation is improved

compared to the proposed interpretation and I am voting in favor of

it. However, I am concerned that this interpretation does not

provide the clarity that may be required.

Staff has done a remarkable job in considering the comments

received and drafting this final interpretation and they deserve

ample praise for their hard work. Yet, staff, and this Commission,

face statutory restrictions regarding the definitions of forwards

and options that place limits on the relief available through

interpretations of the forward contract exclusion. There is no

interpretation, by this Commission or its staff, which can turn an

option into a forward.

Given the interpretive questions about the final rule defining

``swap'' and the difficulties in classifying forward contracts with

embedded optionality, I think it is important to be clear on what

this interpretation can and cannot do--I do not want people to make

business decisions based upon a mistaken belief that they have

received relief when they have not.

The central issue industry faces is that, in the manufacturing,

agriculture and energy sectors, a wide variety of physically-

delivered instruments are used to secure companies' commercial needs

for a physical commodity. These instruments often contain elements

of both a forward contract and a commodity option. These contracts,

particularly in the energy sector, are all commonly referred to as

physical contracts, and they, according to what I have been told,

often receive similar treatment from both a business operations and

an accounting standpoint within the entities that use them.

Furthermore, my understanding is that these physical contracts

are often handled and accounted for separately from other

derivatives, such as futures contracts or cash-settled swaps.

Treating some portion of these physical contracts as swaps simply

because they may contain some characteristics of commodity options

can lead to significant costs and difficulties. For instance,

companies may have to reconfigure their business systems to parse

transactions where there was, before Dodd Frank, no need to

undertake such a reconfiguration.

I have studied this issue closely, meeting with industry and the

public and reviewing the comments we have received. In the case of

these transactions which are used to address physical commodity

needs, I have doubts about whether any public interest is served by

requiring manufacturing, agricultural and energy companies to

undertake such a burden and reconfigure processes to comply with

Commission swap regulations.

The limits on relief through this interpretation flow from the

statutory lines drawn between options and forward contracts. Under

the CEA, options and forwards are discrete, mutually exclusive

categories. Options are subject to the Commission's plenary,

exclusive jurisdiction. Forward contracts, on the other hand, are

almost entirely excluded from the Commission's jurisdiction. If a

contract, or some portion of a contract, meets the definition of an

``option,'' that portion which is an option inherently cannot be a

forward contract.

Under the CEA, a critical difference between a physically-

delivered option and a forward contract is the nature of the

delivery obligation. A forward contract binds both parties to make

and take delivery of a commodity at some date in the future. The

contract may only be offset through a separate negotiation of the

parties. In a physically-settled option contract, only the party

offering the option is bound to make or take delivery at the time of

contract.

The forward contract exclusion from the swap definition, applies

only to a ``[A] sale of a nonfinancial commodity or security for

deferred shipment or delivery, so long as the transaction is

intended to be physically settled.'' The key part of this definition

is that it only applies to a ``sale'' of a commodity. A ``sale''

means that one party has agreed to make and the other to take

delivery of that commodity.\1\

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\1\ The phrase, ``so long as the transaction is intended to by

physically settled,'' has been interpreted by the Commission to be

consistent with its traditional approach to determining whether an

instrument is a forward contract. As was stated in the Commission's

proposed rule,

The CFTC believes that the forward contract exclusion in the

Dodd-Frank Act with respect to nonfinancial commodities should be

read consistently with th[e] established, historical understanding

that a forward contract is a commercial merchandising transaction.

Many commenters discussed the issue of whether the requirement

in the Dodd-Frank Act that a transaction be ``intended to be

physically settled'' in order to qualify for the forward exclusion

from the swap definition with respect to nonfinancial commodities

reflects a change in the standard for determining whether a

transaction is a forward contract. Because a forward contract is a

commercial merchandising transaction, intent to deliver historically

has been an element of the CFTC's analysis of whether a particular

contract is a forward contract. In assessing the parties'

expectations or intent regarding delivery, the CFTC consistently has

applied a ``facts and circumstances'' test. Therefore, the CFTC

reads the ``intended to be physically settled'' language in the swap

definition with respect to nonfinancial commodities to reflect a

directive that intent to deliver a physical commodity be a part of

the analysis of whether a given contract is a forward contract or a

swap, just as it is a part of the CFTC's analysis of whether a given

contract is a forward contract or a futures contract. Proposed Rule

on ``Further Definition of `Swap,' `Security-Based Swap,' and

`Security-Based Swap Agreement'; Mixed Swaps; Security-Based Swap

Agreement Recordkeeping, 76 FR 29818, 29828 (May 23, 2011)

(``Proposed Products Release'').

This interpretation was ratified in the final rule, ``Further

Definition of `Swap,' `Security-Based Swap,' and `Security-Based

Swap Agreement'; Mixed Swaps; Security-Based Swap Agreement

Recordkeeping, 77 FR 48208, 48227-48228 (August 13, 2012)

(``Products Release'').

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[[Page 28244]]

An option, in contrast, is only the option to undertake such a

``sale'', not the sale itself. The sale occurs only when the option

is exercised. The option to buy or sell a commodity at some later

point simply is not the same thing as the sale of that commodity

itself. The Commission's Office of the General Counsel memorialized

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this interpretation in 1985:

[T]he [forward] contract must be a binding agreement on both

parties to the contract: One must agree to make delivery and the

other to take delivery of the commodity. Second, because forward

contracts are commercial, merchandizing transactions which result in

delivery, the courts and the Commission have looked for evidence of

the transactions' use in commerce. Thus, the courts and the

Commission have examined whether the parties to the contracts are

commercial entities that have the capacity to make or take delivery

and whether delivery, in fact, routinely occurs under such contracts

* * * * *

Thus, an option is a contract in which only the grantor is

obligated to perform. As a result, the option purchaser has a

limited risk from adverse price movements. This characteristic

distinguishes an option from a forward contract in which both

parties must routinely perform and face the full risk of loss from

adverse price changes since one party must make and the other take

delivery of the commodity. In contrast, in an option, only the

grantor of a call (put) is required to sell (buy) a given quantity

of a commodity (or a futures contract on that commodity) on or by a

specified date in the future if the option is exercised.

``Characteristics Distinguishing Cash and Forward Contracts and

`Trade Options' '', 50 FR 39656-02 (September 30, 1985)

The Commission ratified this interpretation in 1990 in its

``Statutory Interpretation Concerning Forward Transactions'', 55 FR

39188-03 (September 25, 1990) (``Brent Interpretation'') and again

in 2012 its final rule, ``Further Definition of `Swap,' `Security-

Based Swap,' and `Security-Based Swap Agreement'; Mixed Swaps;

Security-Based Swap Agreement Recordkeeping, 77 FR 48208, 48227-

48235 (August 13, 2012) (``Products Release''). In doing so, the

Commission explicitly rejected the argument that physically-

delivered commodity options could fall within the forward contract

exclusion.\2\

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\2\ See also, Products Release at 4236-37.

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The interpretation being promulgated today does not change this,

and therein lays my concern regarding this interpretation's limits.

I think much of the confusion regarding the seven-part test has

been based upon a failure to recognize the difference between

forward and option contracts under the Commodity Exchange Act. The

fact that a forward contract element and a commodity option are

packaged together does not change the regulatory treatment of the

different components. Hybrid or packaged instruments are common

throughout the industry. There are hybrid or packaged instruments

which may have characteristics of futures contracts and securities,

swaps and security-based swaps, futures and forward transactions,

and even forward contracts and commodity options. Each portion of

the contract might be subject to different regulatory treatment. A

security does not become a future, nor does a future become a

security simply by virtue of being packaged in the same instrument.

Relevant to the instruments we are discussing today, forward

contracts with embedded volumetric optionality, it seems that most

of them, as described in the comments, have at least two separate,

identifiable contractual obligations, each of which must be

considered on their own merits. There is a forward contract element

which binds the parties to make and take delivery of a set amount of

a commodity. In addition, there is an embedded volumetric

optionality element that binds the forward contract offeror to make

or take delivery of an additional amount of the commodity if the

embedded volumetric optionality is exercised by the forward contract

offeree. The latter contractual obligation looks like a classic

option.

The difficulty this interpretation faces in providing the relief

industry seeks is this: Even though the embedded optionality has the

form of an option, can it somehow fit within the forward exclusion?

The answer this interpretation gives is, essentially, yes, it can,

if it can be demonstrated that, despite the embedded optionality

having the form of an option, it is utilized, in practice, as a

forward contract. While the seven-prong test and the interpretive

guidance around it do not provide an exact roadmap for determining

when embedded volumetric optionality included in a forward contract

may or may not fall into the option definition, or when embedded

volumetric optionality may undermine a forward contract, I think it

does provide a good sense of the factors that parties must consider

in making those determinations for themselves.

Such a test, however, is necessarily a facts and circumstances

test with no bright lines. Ensuring compliance with this

interpretation poses a challenge, and, therefore, that is an area

where I would like to see greater legal certainty for these

contracts.

In closing, I support this final interpretation, but I think

industry would benefit from broader relief that provides greater

legal certainty. I look forward to continuing to work with my fellow

Commissioners and staff to make sure that commercial entities have

access to the tools they need to manage the commercial risks of

their operations.

[FR Doc. 2015-11946 Filed 5-15-15; 8:45 am]

BILLING CODE 8011-01-p 6351-01-P

 

Last Updated: May 18, 2015