On November 3, 2014, the CFTC approved a proposal to revise the often confusing “seven-part” test for forward contracts with embedded volume options that the CFTC announced in its final product definition rules (77 Fed. Reg. 48,208).
The CFTC offered the seven-part test as a clarification to help commercial market participants distinguish routine physical forward contracts, which are excluded from the definition of “swap” under the Dodd–Frank Act, from commodity options, which are deemed swaps under Dodd-Frank and which are subject to certain CFTC regulations.
Though helpful in some cases, the test has been difficult to apply in other circumstances.
In issuing its final product definition rules, the CFTC sought comments on the seven-part test. Many market participants filed comment letters addressing the elements of the test (especially the seventh), advocating the elimination of the test in its entirety due to the increased confusion, and arguing that physical commodity options should be excluded entirely from the “swap” definition because they were not intended to be regulated under Dodd-Frank.
On April 3, 2014, the CFTC held a public roundtable discussing, among other things, embedded volume options. This proposal is a result of the public comments and roundtable.
Seventh prong of CFTC’s seven-part test
The seventh-prong of the seven-part test requires that the decision to strike or not to strike the option be 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.”
This language increased ambiguity in distinguishing options from non-options because commercial market participants may have, at the time of a decision to strike a certain “option” contract, many factors to consider.
For example, parties may have more than one such contract to choose from. If there is a non-physical factor among the various contract choices, the presence of more than one contract could, if read literally under the seven-part test, cause a contract to fail the test even though it would have passed if there were only one contract in place.
The CFTC proposes to modify the test based on the intent of the parties at the time they enter into the agreement, rather than the time of the strike, so long as the option is intended from the outset to address physical factors or regulatory requirements that reasonably influence demand for, or supply of, the nonfinancial commodity.
Depending on the proposed language, this change should make it easier for commercial market participants to include contract language that falls within the seven-part test at the outset, as opposed to relying on decisions to be made at the time of striking the option.
In addition, the CFTC proposes that the term “physical factors” be construed broadly to include any fact or circumstance reasonably influencing the parties’ demand for or supply of the commodity underlying the option. This will, according to the CFTC’s Fact Sheet, include environmental factors, relevant “operational considerations,” and broader social forces, such as changes in demographics or geopolitics.
Equally important, the CFTC proposes that concerns primarily about price risk will not satisfy the seventh prong absent an applicable regulatory requirement to obtain or provide the lowest price. This clarification appears to take a step closer to distinguishing purely physical delivery contracts from contracts that have both a delivery component and a price hedge component, such as fixed-price options entered into by market participants who (unlike some gas and electric utilities) are not subject to regulatory requirements to buy from the lowest reasonable price suppliers.
The CFTC also is proposing to clarify that agreements providing for electric demand response―which are measures to be taken to reduce electric load at times of peak demand — may fit within the regulatory requirement component in the seventh prong.
Fourth and fifth prongs of CFTC’s seven-part test
The fourth and fifth prongs of the seven-part test require that the seller and buyer of the commodity intend, “at the time it enters into the agreement,” to physically deliver (or receive) the underlying commodity if the optionality was exercised. But the wording of these prongs was unclear about whether the seller or buyer of a put option, as opposed to a call option, would qualify.
The CFTC is proposing to clarify that the fourth and fifth prongs apply to embedded volumetric optionality in both puts and calls.
The proposed changes to the seven-part test will be subject to a formal comment period. Although the exact language of the proposal is not yet available, the CFTC may post it on its website before it is published in the Federal Register.
Interested parties should monitor this issue closely, as we expect they will likely want to file comments on this important change in interpretation.