Recently, the CFTC published a final interpretation clarifying its seven-element test regarding forward contracts with embedded volumetric optionality (EVO). The final interpretation provides that a contract for deferred delivery of a physical commodity (i.e., a forward contract) that contains EVO will fall within the forward contract exclusion, and thus not be regulated as an option, 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.
Fix to the Problematic Seventh Element
The final interpretation replaces the former seven-element test that was issued in the CFTC’s 2012 rulemaking setting forth a definition of the term “swap.” The seventh element in that test was criticized by numerous industry groups and market participants (particularly in the energy industry) as unworkable–largely because of its explicit focus on the “exercise or non-exercise” of the EVO in a contract. Many considered that focus to require analysis of contracting parties’ intent at the time of exercise or non-exercise of the EVO (as opposed to the time of execution of the underlying contract)—a task considered fraught with uncertainty and unpredictability to the point that many considered reliance on counterparty representations to be untenable.
The final interpretation seems to largely fix that issue by removing the reference to the “exercise or non-exercise” of EVO from the seventh element and instead focusing on “the intent of the party with the right to exercise the embedded volumetric optionality at the time of contract initiation.” Thus, as long as the primary intended purpose for including EVO at the time of contract execution is to address physical factors or regulatory requirements influencing the demand for or supply of the commodity, the ultimate reason for exercise or non-exercise of the EVO (even if it ultimately turns out to be price) should be irrelevant. The CFTC also further advises that 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.”
The final interpretation clarifies that parties having some influence over factors affecting their demand for or supply of the nonfinancial commodity (e.g., the scheduling of plant maintenance, plans for business expansion) should not be considered 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 supply of or demand for the nonfinancial commodity.” It also clarifies that the term ‘‘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—including 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. The CFTC reiterated, however, that if EVO 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).”
Good Faith Reliance on Past Characterizations of Transactions
Although the final interpretation could change the way counterparties previously characterized transactions, the CFTC stated in the final interpretation 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.”
The revised seventh element will likely have the practical effect of extending the forward contract exclusion to many widely used forms of forward contracts in physical commodities that contain EVO to address supply and demand related uncertainties in those commodities. As such, the final interpretation is a welcome result to market participants in affected industries like energy and agriculture.