When Supply Contracts are Considered Swaps: The Effects of the CFTC’s Interpretation of Embedded Volumetric Optionality on Derivatives End-Users

July 29, 2014

As regulators implement Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Dodd-Frank Act"), much of what was left vague in the statute is coming into focus.  However, one area that still looks fuzzy, even upon close inspection, is how the Dodd-Frank Act and the Commodity Futures Trading Commission’s ("CFTC’s") regulations apply to a company’s supply contracts with embedded volumetric optionality.  Commercial end-users utilize numerous supply contracts to ensure that they have agreements in place to manage the purchase and sale of physical commodities related to operating their businesses.  Accordingly, it may not be intuitive to an end-user company that such supply contracts may fall within the CFTC’s definition of "swap" if they contain certain attributes, including embedded volumetric optionality.  As a result, end-users may find that the scope of contracts subject to the Dodd-Frank Act includes not just the derivatives they use in their hedging programs, but also certain of the supply contracts with embedded optionality that are used in their purchasing programs.   

Background 

The definition of "swap" in Commodity Exchange Act ("CEA") Section 1a(47) excludes from such definition "any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled."[1]   This "forward contract exclusion" in the definition of "swap" is in keeping with the CEA’s long-standing exclusion for physically settled futures contracts.[2]   Contracts that qualify for the forward contract exclusion are not subject to the requirements of Title VII of the Dodd-Frank Act or the related CFTC regulations relating to "swaps."[3]   

On August 13, 2012, the CFTC and the Securities and Exchange Commission ("SEC") published a joint rule that further defined the term "swap" and provided some guidance in the preamble on the application of the forward contract exclusion from the definition of swap (the "Product Definitions Rule").[4]  In the Product Definitions Rule, the CFTC discussed optionality within forward contracts and recognized "that the nature of commercial operations are [sic] such that supply and demand requirements cannot always be accurately predicted and that forward contracts that allow for some optionality as to the amount of a nonfinancial commodity actually delivered offer a great deal of value to commercial participants."[5]    

In the same rule, the CFTC provided guidance on when such forward contracts with embedded optionality would qualify for the forward contract exclusion.  In particular, the CFTC provided guidance on when a supply contract with embedded volumetric optionality (i.e., optionality as to the amount of physical commodity to be delivered) would qualify for the exclusion from the definition of swap. 

The CFTC explained that, for a supply a contract with embedded volumetric optionality to qualify for the forward contract exclusion, the facts and circumstances of the contract must satisfy a seven-prong, safe-harbor test.  These seven prongs are as follows: 

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 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 it exercises the embedded volumetric optionality;
6. Both parties are commercial parties; and
7. The exercise or non-exercise of the embedded volumetric optionality is 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.[6] 

The CFTC also clarified in the Product Definitions Rule that full requirements contracts (i.e., contracts where the seller agrees to provide all requirements for a specific customer’s location or delivery point) may qualify for the forward contract exclusion under the same facts and circumstances analysis applicable to other agreements because "the CFTC believes that a going commercial concern with an exclusive supply contract has no option but to get its supply requirements met through that exclusive supplier" and "any variability in delivery amounts under the contract appears to be driven directly by the buyer’s commercial requirements and is not dependent upon the exercise of any commodity option by the contracting party."[7]   

As a result of this CFTC guidance, end-user companies will need to evaluate their supply contracts that contain volumetric optionality (e.g., contracts with the option to take varying amounts of a commodity), and to consider whether a particular contract meets each of the seven prongs noted above.  Some supply contracts will be easy to categorize, while others will be more difficult and require a more thorough analysis of each prong.  We discuss application of the seven prongs, as well as other considerations, in the sections that follow.   

Application of the Seven-Prong Test for Embedded Volumetric Optionality 

To illustrate some of the nuances of the seven-prong test, it is helpful to walk through an example.  Assume that Company ABC has a supply contract specifying that it has the right to take delivery of anywhere from zero to 100 widgets every day for the next three years from Supplier XYZ.[8]  This contract contains volumetric optionality.  In this example, it is Company ABC’s decision whether it takes delivery of widgets, and if so, in what amount.  

One of the most important factors to consider when determining whether the forward contract exclusion will apply is whether the supply contract provides an option to take a nominal or zero physical delivery amount.  Unfortunately, the Product Definitions Rule is ambiguous as to whether a contract that lacks a firm and non-nominal delivery obligation can qualify for the forward contract under this seven-prong test, and the CFTC’s lone example of a contract with embedded volumetric optionality that would satisfy the first two prongs of the test involved a contract with a non-nominal delivery amount.[9] 

This particular supply contract could be found to fail the first and second prongs of the seven-prong test since Company ABC has the option to take a nominal or zero amount of delivery.  As a result, the optionality provision in this supply contract could be viewed as undermining the overall nature of the forward contract because Company ABC has the option to receive no delivery, making the predominant nature of the contract more in the nature of an "option" and not a forward contract that is eligible for the forward contract exclusion.  Accordingly, in this case, the contract would likely be viewed as an "option" and therefore a "swap."[10] 

Changing the facts slightly, if Company ABC had the right to take anywhere from 50 to 100 widgets every day, it seems likely that the predominant nature of the contract would be to receive actual delivery, since there is no option to receive a nominal amount.  Accordingly, the first and second prongs of the seven-prong test likely would be met as a result of the non-nominal amount required to be delivered (regardless of whether or not an option is exercised).  However, Company ABC would need to consider each of the other five prongs.  Assuming that the option is not severable from the supply contract, and that both parties are commercial parties that intend to deliver and receive delivery if the volumetric optionality is exercised, the contract would likely satisfy prongs three through six.     

The seventh prong could prove more problematic.  If the supply contract allows Company ABC not to take the full 100 widgets each day for any reason other than as a result of physical factors (e.g., force majeure, lack of transportation, etc.) or regulatory factors (e.g., a law limits or prevents delivery), then the supply contract may be found to fail the seventh prong, and based on the CFTC’s guidance, could not qualify for the forward contract exclusion.  Accordingly, if the supply contract were to fail the seventh prong, it would be treated as a "swap" or "trade option" depending on the particular facts and circumstances.  Note that, if the supply contract were to specify "Company ABC will take delivery of 100 widgets, unless there is an emergency condition or regulatory event that would require it to take less delivery, in which case Company ABC may take no less than 50 widgets in any given day," then it may satisfy the seventh prong and therefore the forward contract exclusion.   

The seventh prong of this test has caused market participants significant confusion, as it appears to greatly expand the definition of "swap" to focus beyond the intent of the parties to take actual delivery at the time of execution of the contract, to also require parties to focus on the intent of the exercise or non-exercise of the embedded volumetric option.[11]  Accordingly, the seventh prong seems to move beyond the intent element in CEA Section 1a(47)(B)(ii) and even beyond some of the other language in the preamble to the Product Definitions Rule suggesting that parties should evaluate the facts and circumstances at the time of execution of the transaction.[12] 

In the Product Definitions Rule, the CFTC has noted that it "does not interpret [the seventh prong] to mean that absolutely all factors involved in the decision to exercise an option must be beyond the parties’ control, but rather the decision must be predominantly driven by factors affecting supply and demand that are beyond a parties [sic] control."[13]   The CFTC further explained that "[t]o the extent the optionality covers an amount of the commodity in excess of the regulatory requirement, such optionality would not necessarily be covered by this aspect of the guidance, though it may nevertheless be covered by the guidance if such excess volumetric optionality is based on physical factors within the meaning of the guidance.…"[14]  

Does the Supply Contract Qualify as a "Trade Option"? 

If, after analyzing a supply contract based on the seven-prong test, an end-user company determines that such supply contract is a "swap," such swap would be subject to the Dodd-Frank Act rules unless it qualifies for the "trade option" exemption.  If this exemption applies, there still would be reporting, recordkeeping and monitoring requirements; however, exempted trade options are not subject to the full scope of Dodd-Frank Act requirements. 

CFTC Regulation 32.3 provides an exemption for commodity option transactions if a given transaction is offered to a "Commercial User" (as defined below) and meets the following requirements: 

• The offeror must be either
  • An eligible contract participant;[15] or
  • A producer, processor, or commercial user of, or merchant handling, the commodity that is the subject of the commodity option transaction, or the products or by-products thereof, and such offeror (or offeree, as applicable) is offering (or being offered, as applicable) or entering into the commodity option transaction "solely for purposes related to its business as such" (such party, as applicable, a "Commercial User").[16]·        
• The offeree must be a Commercial User.
• With respect to the transaction itself, the commodity option must be intended to be physically settled so that, if exercised, the option would result in the sale of an exempt or agricultural commodity (which includes electricity) for immediate or deferred shipment or delivery. 
  • The CFTC has explained that in order to determine if the parties had an "intent" to physically settle, the CFTC will use the same "facts and circumstances" test used for the forward contract exclusion, weighing heavily the intent of the parties to deliver a physical commodity.

The trade option exemption in CFTC Regulation 32.3 requires that the end-user comply with the CFTC’s Part 45 reporting requirements, position limits and large trader reporting requirements, as these transactions would be commodity options.[17]  However, on April 5, 2013, the CFTC issued CFTC Letter 13-08, which provided no-action relief from the Part 45 reporting requirements for contracts meeting the trade option exemption under CFTC Regulation 32.3 for non-swap dealer/non-major swap participant ("non-SD/non-MSP") counterparties if: 

• All other elements of the trade option exemption are satisfied (including Part 45 recordkeeping requirements);
• The non-SD/non-MSP reports the commodity option transaction on Form TO pursuant to CFTC Regulation 32.3(b)(2);
  • Form TO requires the party to:
    • provide its name and contact information;
    • identify the categories of commodities (agricultural, metals, energy or other) underlying one or more unreported trade options which it entered into during the prior calendar year; and
    • for each commodity category, identify the approximate aggregate value of the underlying physical commodities that it either delivered or received in connection with the exercise of unreported trade options during the prior calendar year (but excluding the value of commodities that were the subject of trade options that remained open at the end of the calendar year or any trade options that expired unexercised during the prior calendar year); and
• The non-SD/non-MSP notifies the CFTC’s Division of Market Oversight through an email to [email protected] no later than 30 days after entering into trade options having an aggregate notional value in excess of $1 billion during any calendar year.

What About Embedded Price Optionality?

In the Product Definitions Rule, the CFTC explained that a forward contract that contains an embedded commodity option with respect to price would not be denied the ability to qualify for the forward contract exclusion for nonfinancial commodities if the following three factors are present: 

1. The embedded optionality may be used to adjust the forward contract price but does not undermine the overall nature of the contract as a forward contract;
2. The embedded price optionality does not target the delivery term, so that the predominant feature of the contract is actual delivery; and
3. The embedded price optionality cannot be severed and marketed separately from the overall forward contract in which it is embedded.[18]

It would appear that, in most cases, contracts with embedded price optionality will satisfy the three-part test.  However, the factors may not be satisfied in situations where the price optionality is a proxy for optionality in terms of delivery.

Other Considerations

The CFTC also provided some additional guidance in the Product Definitions Rule for certain physical commercial contracts for the provision of service, such as tolls on power plants, transportation agreements on natural gas pipelines, and natural gas storage agreements, noting that they would be treated as forward contracts, and therefore excluded from the Dodd-Frank Act requirements relating to "swaps," if the contract satisfies the following three-part test for facility usage agreements: 

1. The subject of the agreement, contract or transaction is usage of a specified facility or part thereof rather than the purchase or sale of the commodity that is to be created, transported, processed or stored using the specified facility;
2. The agreement, contract or transaction grants the buyer the exclusive use of the specified facility or part thereof during its term, and provides for an unconditional obligation on the part of the seller to grant the buyer the exclusive use of the specified facility or part thereof; and
3. The payment for the use of the specified facility or part thereof represents a payment for its use rather than the option to use it.[19]

The CFTC explained that "[i]n such agreements, contracts and transactions, while there is optionality as to whether the person uses the specified facility, the person’s right to do so is legally established, does not depend upon any further exercise of an option and merely represents a decision to use that for which the lessor already has paid."[20]  The CFTC then added the following caveat:  "However, . . . if the right to use the specified facility is only obtained via the payment of a demand charge or reservation fee, and the exercise of the right (or use of the specified facility or part thereof) entails the further payment of actual storage fees, usage fees, rents, or other analogous services not included in the demand charge or reservation fee, such agreement, contract or transaction is a commodity option subject to the swap definition."[21]  This caveat, colloquially known as the "However" paragraph, was clarified by the CFTC’s Office of General Counsel ("OGC"), which stated that the "However" paragraph was not intended to apply to two-part rate contracts if: 

1. a facility usage agreement, contract or transaction … includes a two-part fee structure;
2. the right to use the specified portion of the facility for the term of the agreement, contract or transaction is legally established upon entering into the agreement, contract or transaction;
3. the party who has legally established the right to use the specified portion of the facility for the term of the agreement, contract or transaction pays the Demand Charge/Reservation Fee in a commercially reasonable timeframe;
4. the use of the facility does not depend on the further exercise of an option; and
5. the Usage Fee is in the nature of a reimbursement for the variable costs incurred by the operator of the facility in rendering the service.[22]

If the transaction fails to meet one or more of the conditions above, the OGC cautions that it may or may not be an "option" and that whether it is an "option" will depend on the facts and circumstances of the agreement, contract or transaction as a whole.  Pursuant to the OGC guidance, it appears that many storage, transportation and tolling agreements appear to be consistent with the facility usage interpretation and therefore likely could be characterized as falling within the forward contract exclusion.

State of Play

Concurrent with the release of the Product Definitions Rule, the CFTC requested comments on how the agency should treat supply contracts with embedded volumetric optionality.  The Commission received a number of comments on the topic.  However, the CFTC never issued further guidance or a rule on contracts with embedded optionality, thus leaving market participants uncertain as to whether and how these contracts will be regulated.  More recently, on April 3, 2014, the CFTC held a staff roundtable to discuss end-user issues, including a panel discussing the issue of embedded volumetric optionality.[23] 

Roundtable panelists noted that entities are applying the seven prong test for embedded volumetric optionality differently and are "agreeing to disagree" on the transaction classifications in order to transact, with the ramification that one end-user counterparty may report the transaction on its Form TO (due to its belief that the transaction does not fulfill the seven factors) and the other end-user counterparty may not (due to its belief that the transaction fulfills the seven factors and is excludable as a forward contract).  Panelists noted that the seventh prong remains their primary concern; however. they also pointed out issues with the fourth and fifth prongs (noting that a strict reading could work for "calls" but not for "puts"), that gross notional value should not be applied in the context of trade options and that trade options should be excluded from position limits.

Given the CFTC’s recent interest in addressing the issue of embedded volumetric optionality and the recent change in leadership at the CFTC, the time seems right for the end-user community to make a concerted effort to resolve the ambiguities associated with embedded volumetric optionality in an acceptable way through advocacy with the Commission. 

What Should Commercial End-Users Be Doing?

Commercial end-users should pay careful attention to the CFTC’s treatment of embedded volumetric optionality in supply contracts, as any company that purchases or sells commodities could end up having to shoulder the burden of CFTC rules for swaps.  We recommend that companies review their existing supply contracts that include volumetric optionality provisions to determine whether they might be considered swaps.  Given the many questions unanswered by the CFTC’s guidance, it is likely that an end-user may need to draw its own conclusions with respect to certain supply contracts by analyzing each of the prongs of the seven-prong safe-harbor test.  Depending on an end-user’s degree of familiarity with the CFTC’s regulatory structure for derivatives transactions, it may be advisable to consult with outside counsel.  In all cases, however, we would recommend that the end-user company document clearly its conclusion that a contract falls within the exclusion.

   [1]   See CEA Section 1a(47)(B)(ii).

   [2]   The exclusion in CEA Section 1a(47)(B)(ii) is similar to what is seen in CEA Section 2(a)(1)(A) for which CEA Section 1a(27) defines that "future delivery" does not include "any sale of any cash commodity for deferred shipment or delivery." 

   [3]   It is also important to note that under the CEA, "options" are considered to fall within the definition of "swap."  See CEA Section 1a(47)(A)(vi) ("any combination or permutation of, or option on, any agreement, contract, or transaction described in clauses (i) through (iv)").

   [4]   Further Definition of "Swap," "Security-Based Swap," and "Security-Based Swap Agreement"; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 Fed. Reg. 48,208 (Aug. 13, 2012).

   [5]   77 Fed. Reg. at 48,238-39.

   [6]   77 Fed. Reg. at 48,238.

   [7]   77 Fed. Reg. at 48,239.

   [8]   For purposes of this example, assume that a "widget" is a "commodity" under CEA Section 1a(9).

   [9]   The CFTC’s only example was a transaction that calls for the delivery of 10,000 bushels of wheat and includes an option for an additional 5,000 bushels of wheat.  77 Fed. Reg. at 48,238-39.

  [10]   The CFTC also clarified in the Product Definitions Rule that evergreen provisions or extension terms in commercial contracts will not render such a contract ineligible for the forward contract exclusion because such provisions do not "target the delivery term," because the embedded option does not affect the delivery amount.  See 77 Fed. Reg. at 48,240.

  [11]   The seventh prong also seems to require the parties to review the intent of exercising or not exercising such embedded volumetric options at the time exercise rather than at the time of execution of the contract. 

  [12]   See 77 Fed. Reg. at 48,228, 48,239, n.344.

  [13]   77 Fed. Reg. at 48,238, n.341.

  [14]   77 Fed. Reg. at 48,238, n.340.

  [15]   See CEA Section 1a(18) and CFTC Regulation 1.3(m)(7).

  [16]   CFTC Regulation 32.3(a)(2).

  [17]   CEA section 1a(47)  defined the term "swap" to include not only "any agreement, contract, or transaction commonly known as," among other things, "a commodity swap," but also "[an] option of any kind that is for the purchase or sale, or based on the value, of 1 or more . . . commodities . . . ."  In the context of CFTC Regulation 32.3, the CFTC uses the term "commodity option" to apply solely to commodity options not excluded from the swap definition set forth in CEA Section 1a(47)(A).  See Commodity Options, 77 Fed. Reg. 25,320, 25,322 (Apr. 27, 2012).  Commodity options are subject to the same rules as all other "swaps" with certain exemptions, such as the "trade option exemption" from certain swap regulations.

  [18]   77 Fed. Reg. at 48,237.

  [19]   77 Fed. Reg. at 48,242.

  [20]   Id.

  [21]   Id.

  [22]   Office of General Counsel ("OGC") Response to Frequently Asked Questions Regarding Certain Physical Commercial Agreements for the Supply and Consumption of Energy, available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/leaselike_faq.pdf.

  [23]   See Press Release, CFTC Staff to Host Public Roundtable to Discuss Dodd-Frank End-User Issues, available at http://www.cftc.gov/PressRoom/PressReleases/pr6872-14.  The panelists included: Paul Hughes (Southern Company), Wally Turbeville (Demos), Tom Nuelle (BP), James Allison (ConocoPhillips), Jerry Jeske (Mercuria), Susan Bergles (Northwest Natural Gas Company and the American Gas Association) and David Perlman (Coalition of Physical Energy Companies).

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