According to CFTC statements made today, the CFTC’s final “swap” definition rule follows the basic framework set out in the proposed rule with respect to the statutory exclusion of forward physical contracts, i.e., “any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled,” from the definition of the term “swap.” Although the text of the rule has not been released, Commissioner statements and a fact sheet released today indicate that the forward contract exclusion will be interpreted in a manner consistent with the CFTC’s historical interpretation of the existing forward exclusion with respect to futures contracts.
In particular, the principles underlying the CFTC’s “Brent Interpretation” with respect to “book-out” transactions will apply to the forward exclusion from the definition of “swaps.” Accordingly, a financially-settled book-out of a transaction contractually required to be physically settled should qualify for the exclusion if the counterparties are commercial market participants who regularly make or take delivery of the referenced commodity in the ordinary course of business and the book-out was effectuated through a subsequent, separately negotiated agreement. The Commission also clarifies that oral book-outs are permissible if they are followed by a written or electronic confirmation.
Forward Contracts With Embedded Volumetric Optionality
Forward contracts with embedded optionality posed a unique issue to the Commission in that “options” are explicitly identified as “swaps” by the Dodd-Frank Act, yet industry participants identified that a vast swath of industry contracts that call for deferred delivery of physical commodities contain embedded optionality yet were not intended to be regulated as swaps under the Act. The Commission recognized industry concerns by expanding its interpretation of the exclusion with respect to such contracts. Whereas the proposed rule allowed optionality only with respect to the price term, the final rule recognizes that forward contracts with embedded optionality with respect to volume or quantity can also qualify for the exclusion. Commission statements indicate that such contracts must satisfy a seven-factor test, including a requirement that the volumetric optionality be due to physical factors or regulatory requirements beyond the control of the parties, to qualify for the exclusion. According to Commission O’Malia, a contract should satisfy the test if its predominate feature is actual delivery. Commissioner Wetjen worried that the seven-factor test may “needlessly complicate” commercial practices.
The Commission provided additional guidance that:
– Environmental commodities, such as offsets, allowances, and Renewable Energy Credits (RECs) are nonfinancial commodities eligible for the exclusion;
– Energy management agreements do not alter the nature of the transactions conducted under them for purposes of the exclusion;
– Certain types of arrangements as described in the release, such as fuel delivery agreements and physical exchange transactions, are not swaps;
– Certain physical commercial arrangements that are similar to leases are not options and may qualify for the forward exclusion under the facts and circumstances; and
– Certain contract provisions do not disqualify transactions for the forward exclusion (e.g., liquidated damages, renewal/evergreen provisions).