On May 18, 2015, the CFTC published in the Federal Register its final revised 7-part Interpretation regarding “forward contracts with embedded volumetric optionality.” The final guidance provides useful clarification in determining when a contract with an embedded volumetric option qualifies for the forward contract exclusion from the “swap” and “future delivery” definitions under the Commodity Exchange Act.
History of the Seven-Part Test
The CFTC’s “Product Definitions Release” set forth seven factors to analyze when determining whether an agreement qualifies for the forward contract exclusion despite potential variations in the delivery amount over the term of the contract—what the CFTC called “embedded volumetric optionality.” But commercial market participants found that the Interpretation created uncertainty as to how applicable contracts should be characterized.
Final Interpretation
The CFTC’s recent final Interpretation revised parts four, five and seven of the original 7-part Interpretation. It revised the fourth and fifth factors to clarify that either puts or calls can qualify for the forward contract exclusion. The CFTC also clarified that the fourth and fifth factors do not prevent “swing” contracts—which allow for delivery of the applicable contract quantity in a range between a stated minimum and maximum amount—from qualifying for the forward contract exclusion, so long as the other elements of the Interpretation are satisfied.
The bulk of the CFTC’s final Interpretation, however, addressed the seventh factor. As revised, the seventh factor now provides that a contract may be an excluded forward contract notwithstanding an embedded volumetric option if:
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.
Although the CFTC stated that it would continue to assess the intent of the parties according to the facts and circumstances surrounding the agreement, under the revised Interpretation, the relevant intent is that which exists when the option is entered into, not when it is exercised.
The CFTC also said that it would broadly interpret the seventh factor to consider any “physical factors” that affect supply of, or demand for, the applicable commodity. Such factors might 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.
Such factors also can include regulatory requirements, such as the obligation to safeguard the reliability of the electric grid. Moreover, the parties can satisfy the seventh factor even if they have some influence over the applicable physical factor, for example vis-a-vis maintenance schedules or business expansion plans, so long as the parties included the embedded optionality primarily to address fluctuations in demand or supply.
The CFTC drew the line, however, with respect to contracts that include volumetric optionality primarily to manage price risk. Nevertheless, the CFTC said that a regulatory requirement for a cost-of-service regulated utility to obtain the lowest price or provide such price to its counterparty could qualify as a physical factor and still satisfy the seventh factor of the Interpretation.
Finally, the CFTC clarified that:
- Commercial parties can rely on representations as to the intent of their counterparties, and they are not required to conduct due diligence with respect to their counterparty’s intent; and
- Parties can either continue to rely on their good-faith characterization of an existing contract, or re-characterize their treatment of existing contracts pursuant to the revised Interpretation.
Concluding Thoughts
The revised Interpretation does not provide clarity as to whether it applies to all forms of volumetric optionality, or only to those that constitute options under the CFTC’s historical definition of that term. In any event, though, the CFTC’s changes to part seven of its Interpretation should make it easier for parties to demonstrate their primary intent to address physical or regulatory concerns regarding the supply or demand of a commodity, since they may now demonstrate that intent at the time of execution—via representations and contract language. The CFTC’s pronouncements regarding the breadth of permissible physical factors and the implications of having some control over those physical factors should further remove uncertainty from the determination of whether an agreement is an excluded forward contract.
But the Interpretation remains, at its core, highly fact-specific and open-ended. Of interest in this regard is the call by Commissioner Bowen in her concurring statement for “broader relief that provides greater legal certainty.”
Market participants should nevertheless welcome the clarification that the CFTC has provided. This is particularly true since it goes hand-in-hand with the recent CFTC Proposal (discussed in last week’s Blog Post) to reduce the regulatory burdens on commercial end-users with regard to transactions that, based on an application of the 7-part Interpretation, are trade options as opposed to excluded forwards.
