On May 12, 2015, the U.S. Commodity Futures Trading Commission (CFTC) issued its final interpretation (Final Interpretation) to clarify when a nonfinancial commodity contract that contains “embedded volumetric optionality” (EVO) is a forward, exempt from Dodd-Frank compliance obligations, rather than a swap or commodity trade option, subject to Dodd-Frank reporting, recordkeeping and other requirements.
Many commercial end-users enter into forward contracts with EVO to address uncertainty in the supply or demand of energy or agricultural commodities. Manufacturing supply contracts for the purchase of raw materials may provide for the purchase “up to” a certain amount or within varying levels, or otherwise provide for price adjustments under certain conditions. In the energy industry, contracts with a plus or minus delivery term might be used to adjust the amount of the commodity delivered. For instance, a power plant that transacts for a baseload amount of gas will need the ability to “swing” up or down by a certain percentage based on operational factors. Peaking supply agreements, capacity contracts, transmission (or transportation) service agreements and tolling agreements may have volumetric optionality features commonly used by many industrial and energy market participants to ensure the supply of, or demand for, a commodity needed to operate a business.
Is EVO Apropos?
In August 2012, the CFTC released its final rules defining a “swap” (the Swap Definition Release). In the Swap Definition Release, the CFTC confirmed that forward delivery contracts are excluded from most of the requirements applicable to swaps and commodity trade options. However, the CFTC’s definition of forward delivery contracts with EVO created uncertainty for market participants. In November 2014, the CFTC released its proposed interpretation (the Proposed Interpretation) to clarify when an agreement with EVO would be properly considered a forward contract. The CFTC’s Proposed Interpretation included the seven element test originally set out in the Swap Definition Release. The seven elements contained in the Final Interpretation are marked against the elements from the Swap Definition Release as follows:
- The embedded optionality does not undermine the overall nature of the agreement, contract or transaction as a forward contract;
- The predominant feature of the agreement, contract or transaction is actual delivery;
- The embedded optionality cannot be severed and marketed separately from the overall agreement, contract or transaction in which it is embedded;
- 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;
- 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 is exercised;
- Both parties are commercial parties; and
- The exercise or non-exercise of embedded volumetric optionality is based primarily intended, at the time that the parties enter into the agreement, contract, or transaction, to address on physical factors or regulatory requirements that are outside the control of the parties and are influencing reasonably influence demand for, or supply of, the nonfinancial commodity.
In the Final Interpretation, the CFTC clarified the fourth and fifth elements to refer to EVO in the form of both puts and calls. For the fourth and fifth elements, the CFTC stated that its Final Interpretation does not preclude bandwidth (“swing”) contracts, which provide for delivery of a nonfinancial commodity within a certain minimum and maximum range, from falling within the forward contract exclusion. Further, an extension term or an evergreen provision in a commercial contract (each of which would require additional deliveries) does not, in itself, render such contracts ineligible for classification as forwards.
Most of the action is in the CFTC’s change to the seventh element. Market participants criticized the CFTC’s Swap Definition Release for several reasons, but especially on the basis that (1) it required the parties to analyze the contract based on factors at the time of exercise or non-exercise and (2) whether a factor was “outside the control” of the parties was difficult to apply, often leading to divergent views among parties to the same agreement. To address the first issue, the CFTC’s Final Interpretation changed the focus of the analysis to the primary need for EVO at the time the parties enter into the contract, rather than on the reason for each exercise of optionality, because the former can be shown prospectively while the latter can be known only after the fact. To address the second issue, the CFTC replaced the reference to physical factors or regulatory requirements being ‘‘outside the control of the parties’’ with a focus on those factors or requirements that “reasonably influence” a party’s demand for, or supply of, a physical commodity. While ascertaining intent is a facts and circumstances inquiry, end-users can rely on counterparty representations as to the intended purpose of the contract, provided they do not have information that would cause a reasonable person to question the accuracy of the representation. End-users may want to review their trading agreements to include such counterparty representations.
This change is significant for end-users. A utility, local distribution company or cogeneration plant may have a portfolio of contracts and assets it uses to respond to changes in demand or supply. Other arrangements may include peaking supply contracts documented under an NAESB Base Contract, spot contracts and off- or on-system storage agreements. This portfolio may mean that the entity has a choice about which contracts or assets to use to meet the needs of its customers and may be especially important when facing curtailment issues as a result of weather or other factors. Many market participants in the energy and power space are under a regulatory obligation to ensure system reliability or provide the lowest reasonable cost or obtain the lowest price. If the entity had an alternative to meet its supply needs, then arguably the seventh prong would not have been satisfied under the Swap Definition Release. This resulted in classification of the contract as a swap or commodity trade option, subject to reporting, recordkeeping and other requirements. The CFTC’s Final Interpretation removes this burden from end-users by clarifying that, although the parties may have some influence over factors affecting the volume supplied or delivered, such optionality is not inconsistent with the seventh element, provided that the EVO is included in the contract at initiation primarily to address potential variability in a party’s demand for, or supply of, the commodity.
The CFTC indicated that the reference in the seventh prong to “physical factors” should be construed broadly to include environmental factors, such as weather or location, operational considerations (e.g., the availability of reliable transportation or technology), and broader social forces, such as changes in demographics or geopolitics.
The CFTC also responded to industry concerns about the potential problem of reclassifying existing contracts by permitting parties to rely on good faith characterizations of existing contracts as an EVO or commodity trade option. Future contracts should be characterized in accordance with the Final Interpretation.
While the price is likely to be a consideration for any contract, the primary purpose of a forward contact must be to transfer ownership of the commodity and not to transfer solely the price risk. If the EVO is primarily intended, at contract initiation, to address concerns about price risk (e.g., to protect against increases or decreases in cash market price), the contract will not satisfy the seventh element absent an applicable regulatory requirement. In this case, the contact may still be classified as a commodity trade option. Even if the contract is a trade option, end-users may benefit from the CFTC’s recent Notice of Proposed Rulemaking for reducing the trade option reporting and recordkeeping requirements for end-users. For more information, read our Swaps End-User Update on the CFTC’s proposed commodity trade option reporting and recordkeeping relief.
The CFTC’s Final Interpretation is welcome news to many commercial end-users. Energy and agricultural end-users should review their commodity reporting and recordkeeping policies and procedures to confirm which contracts should be appropriately considered forward delivery contracts, rather than trade options or swaps, based on the Final Interpretation.
Please contact one of the authors or your regular McGuireWoods lawyer if you have questions about your institution’s classification of contracts containing embedded optionality as excluded forwards, commodity trade options, or swaps.