The U.S. House of Representatives has passed H.R. 4413, a bill that would reauthorize the Commodity Futures Trading Commission (CFTC) and also make some important changes to the Commodity Exchange Act (CEA), including changing the definition of the term “swap” in a way that would benefit certain physical market participants. H.R. 4413, which currently is awaiting Senate consideration, would give much-needed clarity to physical market participants who have struggled with the CFTC’s interpretation of its authority to regulate physical “options” as “swaps” under the Dodd–Frank Act by exempting most physical options from the CEA’s swap definition.
The Commodity Option Problem
Dodd-Frank defined a “swap” to include a “put, call, cap, floor, collar, or similar option of any kind.” Despite industry arguments that physical delivery contracts were not intended to be regulated as swaps, the CFTC, in its rulemakings, stuck with its interpretation that physical commodity options may indeed fall within the Dodd-Frank swap definition. However, to avoid burdensome, and probably unworkable, regulation of physical commodity contracts, the CFTC exempted certain commodity options from most Dodd-Frank requirements, namely, those qualifying as “Trade Options” under the CFTC’s rules.
To qualify as a Trade Option, a commodity option must satisfy the following conditions:
(1) The offeree of the option must be a producer, processor, commercial user of or merchant handling the commodity, and be entering into the option solely related to its business as such (i.e., a “commercial market participant”);
(2) The offeror of the option must be either a commercial market participation or an “eligible contract participant” (“ECP”) under the CEA; and
(3) The option, if exercised, must be intended to be physically settled such that the resulting sale would be a spot or forward transaction.
Contractual Trade Option Language
Under CFTC precedent, and as reiterated in the CFTC’s final product definition rules further defining the term “swap” (77 Fed. Reg. 48,208), the determination of whether a contract constitutes an option depends on the “facts and circumstances” of the transaction, which includes the economic reality of the contract, the parties’ intent, and other salient facts. Likewise, the Trade Option regulations require that the option offeror have “a reasonable basis to believe” that the Trade Option requirements have been met, and also requires that the parties intend the option to be physically settled. Commercial parties have therefore taken steps to assess and document whether their contracts constitute options and/or qualify as Trade Options, including adding:
(1) Brief opinions to their contract files that the contract is or is not an option and/or meets the Trade Option requirements; and
(2) Representations or warranties to the contract that indicate its status or non-status as an option, or that satisfy the Trade Option requirements.
This approach has been cumbersome, however, in part because of confusion over the CFTC’s own guidance on whether certain volumetric option contracts may or may not pass the “7-part test” for excluded forward contracts. This confusion especially applies to the seventh prong of the test regarding whether the “exercise or non-exercise of the embedded volumetric optionality is based primarily on physical factors” beyond the parties’ control (thereby excluding them from regulation), and also because parties are not always in agreement about how to treat certain contracts.
Treatment of Options Under H.R. 4413
H.R. 4413 would solve many of the option-determination problems caused by the CFTC’s broad conclusion that physical commodity option contracts may be swaps under Dodd-Frank by removing most of those contracts from the swap definition. Specifically, H.R. 4413 would add a new definition of “commercial market participant,” which generally tracks the “producer, processor, merchant, and commercial user” formulation in the Trade Option rules. Further, the bill would add an exemption to the swap definition for “stand-alone or embedded” options that are intended to be physically settled and are between commercial market participants, among other things. The upshot of this change is that the vast majority of all physically-settled options between commercial market participants would be exempt from Dodd-Frank regulations, including Trade Option regulations. This change likely would be retroactive to the effective date of the Dodd-Frank Act.
Until the bill is signed into law, commercial market participants will still likely find it necessary to assess their option contracts, make any necessary determinations, and add any contract language they feel is necessary to clarify the intent of the agreement, as they have been doing. However, those assessments and any contract language should keep in mind that the option and Trade Option requirements may no longer apply if the House reauthorization provisions are enacted. Therefore, parties may want to qualify language to account for that possibility. For example, if a contract addition proposes that the parties “shall” treat a qualifying transaction as a Trade Option and report it in accordance with CFTC rules, the parties may want to add qualifying language, such as the phrase “if applicable,” to ensure that they will not need to comply with any reporting or other rules if the option falls outside of the CEA.