CFTC's General Counsel Issues Clarification Regarding Two-Part Rate Transactions

November 16, 2012

By Lisa Epifani, Howard Shapiro, Curt Moffatt, Paul Korman, Malcolm McLellan

On November 14, 2012, the Office of General Counsel (“OGC”) of the Commodity Futures Trading Commission (“CFTC”) issued a response to clarify that certain physical commercial contracts for the provision of energy that employ two-part rates are not intended to be regulated as swaps by the CFTC, if they meet certain requirements. Click here to read the OGC Response to Frequently Asked Questions Regarding Certain Physical Commercial Agreements for the Supply and Consumption of Energy.

SWAPS, FORWARDS, AND THE DODD-FRANK ACT

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”) expanded the CFTC jurisdiction to regulate “swaps” under the Commodity Exchange Act (“CEA”). Excluded, however, from the term “swap” are forward transactions involving nonfinancial commodities that are “intended to be physically settled.” Under the CEA, “commodities” include both goods and services; energy commodities include energy products like electricity and natural gas as well as energy services like transmission, transportation, and storage. Entities engaging in swaps may be subject to a myriad of regulations such as registration requirements; business conduct standards; clearing and exchange trading, capital and margin requirements; position limits (currently vacated but being appealed by the CFTC); and various reporting and recordkeeping duties (collectively “swap regulations”). Even if an agreement is a forward, it is not excluded from the CFTC’s anti-fraud and anti-manipulation authority.

DEFINING "SWAP" BY RULE

On August 13, 2012, the CFTC and the Securities and Exchange Commission (“SEC”) published their joint Final Products Rule in the Federal Register. This rule is intended to provide guidance on what is and is not a CFTC-swap regulated swap by further defining the terms “swap,” “security-based swap,” and “security-based swap agreement.” In the Final Products Rule, the CFTC requested comments on its interpretation concerning forwards with embedded volumetric optionality, but it is not clear at this stage if and when the CFTC might act on the submitted volumetric optionality comments.

The Final Products Rule provides that certain physical commercial contracts for the provision of a service, such as tolls on power plants, transportation agreements on natural gas pipelines, and natural gas storage agreements, will be treated as forward contracts, not swaps, if the contracts satisfies a “Three-Part Facility Use Test:”

  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.

The CFTC’s initial explanation of this guidance then added the following caveat: “However…if the right to use the specified facility requires further payment of actual storage fees, usage fees, rents, or other analogous service charges on top of a demand charge or reservation fee, such a transaction is a commodity option subject to the swap definition.”

The “However Paragraph” seemed to threaten imposition of CFTC swap regulation on standard electric transmission, gas transportation and gathering, and storage transactions that use a two-part rate structure that recovers fixed costs in an up-front payment, and defers recovery of variable costs until performance. To avoid this outcome, various energy companies and associations submitted comments and requests for No-Action Letters to the CFTC seeking to eliminate, or at least clarify, the CFTC’s regulatory threat to standard two-part rate agreements.

For example, gas pipeline interests argued to the CFTC that their transportation, gathering, and storage agreements with two-part fee structures would not meet the definition of swap or option under Dodd-Frank or CFTC precedent, but for the “However Paragraph.” Rather, such contracts are best described as sales of nonfinancial commodities for deferred shipment or delivery. The key characteristic of such contracts is the intent to physically settle the contract’s obligations. Therefore, such contracts should qualify for the forward exclusion for nonfinancial commodities from the swap definition.

THE OGC'S CLARIFICATION OF THE "HOWEVER PARAGRAPH"

OGC’s November 14 statement represents only the view of that office and does not bind the Commission or any other office of the CFTC. OGC asserts 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….

The OGC cautions, however, that if the transaction “fails to meet one or more of the conditions above [it] may or may not be an option. Whether such an agreement, contract or transaction is an option depends on the specific facts and circumstances of the agreement, contract or transaction as a whole.” (Emphasis added.)

IMPLICATIONS

The OGC’s new five-part test offers additional guidance, which while arguably cumbersome and somewhat complicated, appears to provide energy companies adequate clarification to help them determine whether a transaction is or is not a swap. Energy companies must examine all their transactions carefully to ensure compliance with the new regulatory landscape under Dodd-Frank. Van Ness Feldman is assisting energy companies to conduct “audits” and to develop tailored compliance guidelines for their risk management practices.

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Van Ness Feldman monitors and interprets CFTC developments; provides strategic counsel on company-specific impacts and potential responses; drafts and submits comments on proposed CFTC rulemakings; and arranges meetings with CFTC officials. For further information about the joint final rule or other Dodd-Frank rulemakings, please contact Lisa Epifani (202.298.1947, lee@vnf.com), Curt Moffatt (202.298.1885, jcm@vnf.com), or Malcolm McLellan (206.829.1814, mcm@vnf.com).

Earlier this year, Van Ness Feldman expanded its capabilities by combining practices with the Seattle law firm of GordonDerr LLP, a preeminent real estate, land use, water law, and civil litigation firm in the Pacific Northwest. Learn more at www.vnf.com.