
[Federal Register Volume 79, Number 224 (Thursday, November 20, 2014)]
[Proposed Rules]
[Pages 69073-69078]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2014-27285]


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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 1

RIN 3038-AE24

SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 230, 240 and 241

[Release No. 33-9681; 34-73584; File No. S7-16-11]
RIN 3235-AK65


Forward Contracts With Embedded Volumetric Optionality

AGENCY: Commodity Futures Trading Commission; Securities and Exchange 
Commission.

ACTION: Proposed interpretation.

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SUMMARY: In accordance with section 712(d)(4) of the Dodd-Frank Wall 
Street Reform and Consumer Protection Act (the ``Dodd-Frank Act''), the 
Commodity Futures Trading Commission (the ``CFTC'') and the Securities 
and Exchange Commission (``SEC''), after consultation with the Board of 
Governors of the Federal Reserve System (``Board of Governors''), are 
jointly issuing the CFTC's proposed clarification of its interpretation 
concerning forward contracts with embedded volumetric optionality. The 
CFTC invites public comment on all aspects of its proposed 
interpretation.

DATES: Comments must be received on or before December 22, 2014.

ADDRESSES: You may submit comments, identified by RIN number 3038-AE24, 
by any of the following methods:
     CFTC Web site: at http://comments.cftc.gov. Follow the 
instructions for submitting comments through the Web site.
     Federal eRulemaking Portal: http://www.regulations.gov. 
Follow the instructions for submitting comments.
     Mail: Secretary of the Commission, Commodity Futures 
Trading Commission, Three Lafayette Centre, 1155 21st Street NW., 
Washington, DC 20581.
     Hand Delivery/Courier: Same as Mail, above. Please submit 
your comments using only one method.
    All comments must be submitted in English, or if not, accompanied 
by an English translation. Comments will be posted as received to 
www.cftc.gov. You should submit only information that you wish to make 
available publicly. If you wish the CFTC to consider information that 
you believe is exempt from disclosure under the Freedom of Information 
Act, a petition for

[[Page 69074]]

confidential treatment of the exempt information may be submitted 
according to the procedures established in Sec.  145.9 of the CFTC's 
regulations, 17 CFR 145.9.
    The CFTC reserves the right, but shall have no obligation, to 
review, pre-screen, filter, redact, refuse or remove any or all of a 
submission from http://www.cftc.gov that it may deem to be 
inappropriate for publication, such as obscene language. All 
submissions that have been redacted or removed that contain comments on 
the merits of the notice will be retained in the public comment file 
and will be considered as required under all applicable laws, and may 
be accessible under the Freedom of Information Act.

FOR FURTHER INFORMATION CONTACT: CFTC: Elise Pallais, Attorney Advisor, 
(202) 418-5577, epallais@cftc.gov, Office of the General Counsel, 
Commodity Futures Trading Commission, 1155 21st Street NW., Washington, 
DC 20581. SEC: Carol McGee, Assistant Director, (202) 551-5870, 
mcgeec@sec.gov, Office of Derivatives Policy, Division of Trading and 
Markets, Securities and Exchange Commission, 100 F Street NE., 
Washington, DC 20549.

SUPPLEMENTARY INFORMATION:

I. Introduction

    In Further Definition of ``Swap,'' Security-Based Swap,'' and 
``Security-Based Swap Agreement''; Mixed Swaps; Security-Based Swap 
Agreement Recordkeeping (the ``Products Release''), the CFTC provided 
an interpretation, in response to requests from commenters, with 
respect to forward contracts that provide for variations in delivery 
amount (i.e., that contain ``embedded volumetric optionality'').\1\ 
Specifically, the CFTC identified when an agreement, contract, or 
transaction would fall within the forward contract exclusion from the 
``swap'' and ``future delivery'' definitions in the Commodity Exchange 
Act (the ``CEA'') \2\ notwithstanding that it contains embedded 
volumetric optionality.\3\ In providing its interpretation, the CFTC 
was guided by and sought to reconcile agency precedent regarding 
forward contracts containing embedded optionality \4\ with the 
statutory definition of ``swap'' in section 1a(47) of the CEA, which 
provides, among other things, that commodity options are swaps, even if 
physically settled.\5\
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    \1\ See 77 FR 48207, 48238-42 (Aug. 13, 2012).
    \2\ See 7 U.S.C. 1a(47)(B)(ii) (excluding from the definition of 
``swap'' ``any sale of a nonfinancial commodity or security for 
deferred shipment or delivery, so long as the transaction is 
intended to be physically settled''); 1a(27) (excluding from the 
definition of ``future delivery'' ``any sale of any cash commodity 
for deferred shipment or delivery'').
    \3\ See 77 FR 48238-42 & n.335. See also id. at 48227-36 
(providing the CFTC's interpretation regarding the forward contract 
exclusion for nonfinancial commodities).
    \4\ See id. at 48237-39 (citing In re Wright, CFTC Docket No. 
97-02, 2010 WL 4388247 (CFTC Oct. 25, 2010), and Characteristics 
Distinguishing Cash and Forward Contracts and ``Trade'' Options, 50 
FR 39656 (Sept. 30, 1985) (``1985 CFTC OGC Interpretation'')).
    \5\ See id. at 48236-37; 7 U.S.C. 1a(47)(A)(i) (defining 
``swap'' to include ``[an] option of any kind that is for the 
purchase or sale, or based on the value, of 1 or more . . . 
commodities . . .'') (emphasis added). Part 32 of the CFTC's 
regulations includes an exemption for certain physically settled 
options, termed ``trade options.'' See 17 C.F.R. 32.3. The trade 
option exemption is currently subject to CFTC staff no-action 
relief. See CFTC Letter No. 13-08 (April 5, 2013), available at 
http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/13-08.pdf.
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    The CFTC has received several comments from market participants 
requesting that it modify or further clarify its interpretation.\6\ 
According to commenters, uncertainty with regard to the meaning of 
certain language in the CFTC's interpretation, particularly the seventh 
element, has led to confusion among market participants with regard to 
how to characterize certain transactions, whether as excluded forward 
contracts with embedded volumetric optionality or regulated trade 
options.
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    \6\ The Products Release included a request for comment on the 
CFTC's interpretation. See 77 FR 48241-42. CFTC staff also solicited 
comments in connection with a public roundtable to discuss issues 
concerning end users and the Dodd-Frank Act. These comments are 
available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1256 and http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1485, respectively.
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II. Proposed Interpretation

    In response to commenters, the CFTC is proposing to clarify its 
interpretation of when an agreement, contract, or transaction with 
embedded volumetric optionality would be considered a forward 
contract.\7\ Accordingly, the CFTC is proposing to provide that an 
agreement, contract, or transaction falls within the forward exclusion 
from the swap and future delivery definitions, notwithstanding that it 
contains embedded volumetric optionality, when:
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    \7\ Section 712(d)(4) provides that ``[a]ny interpretation of, 
or guidance by either Commission regarding, a provision of this 
title, shall be effective only if issued jointly by the Commodity 
Futures Trading Commission and the Securities and Exchange 
Commission, after consultation with the Board of Governors, if this 
title requires the Commodity Futures Trading Commission and the 
Securities and Exchange Commission to issue joint regulations to 
implement the provision.'' While the Dodd-Frank Act would require 
this interpretation to be issued jointly by the CFTC and the SEC, it 
would be an interpretation solely of the CFTC and would not apply to 
the exclusion from the swap and security-based swap definitions for 
security forwards or to the distinction between security forwards 
and security futures products.
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    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 embedded 
volumetric 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 the embedded 
volumetric optionality is exercised;
    6. Both parties are commercial parties; and
    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.
    The first six elements are largely unchanged from the Products 
Release.\8\ Among them, the CFTC is proposing to modify only the fourth 
and fifth elements, to clarify that the CFTC's interpretation applies 
to embedded volumetric optionality in the form of both puts and 
calls.\9\ Accordingly, the CFTC's discussion of these six elements in 
the Products Release would remain relevant and applicable.\10\
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    \8\ See 77 FR 48238.
    \9\ As described in the Products Release, the fifth element did 
not appear to contemplate circumstances where the seller of the 
nonfinancial commodity might exercise the embedded volumetric 
optionality. See 77 FR 48238 (``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.'') (emphasis added).
    \10\ See 77 FR 48238-39.
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    The seventh element addresses the primary reason for including 
embedded

[[Page 69075]]

volumetric optionality in a forward contract. As commenters have 
explained, commercial parties are often unable to accurately predict 
their exact delivery needs or production capacity for a given 
nonfinancial commodity at contract initiation due to a variety of 
factors, such as weather and certain other ``operational 
considerations'' (e.g., transportation capacity).\11\ The embedded 
volumetric optionality therefore offers commercial parties the 
flexibility to vary the amount of the nonfinancial commodity delivered 
during the life of the contract in response to uncertainty in the 
demand for or supply of the nonfinancial commodity.\12\
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    \11\ See, e.g., Letter from ONEOK, Inc. (July 22, 2011) at 4 
(stating that ``day-to-day changes in demand'' for natural gas ``may 
be caused by variation in weather, operational considerations, or 
other factors''); Letter from the American Gas Association (Oct. 12, 
2012) at 9 (stating that ``weather-sensitive demands'' for natural 
gas ``cannot be accurately predicted in advance'').
    \12\ See, e.g., Letter from the Commodity Markets Council, the 
National Corn Growers Association, and the Natural Gas Supply 
Association (April 17, 2014) at 2 (``Physical end-users need these 
contracts to address supply input or production output uncertainty 
associated with the operation of a physical business.''); Letter 
from the Plains All American Pipeline, L.P. (April 17, 2014) at 2 
(``Such contracts provide us with the ability to allow our customers 
flexibility to increase or decrease the amount of purchase or sale 
of a commodity in response to prevailing market conditions.'').
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    The seventh element ensures that this purpose, consistent with the 
historical interpretation of a forward contract,\13\ is the primary 
purpose for including embedded volumetric optionality in the contract. 
In other words, the embedded volumetric optionality must primarily be 
intended as a means of assuring a supply source or providing delivery 
flexibility in the face of uncertainty regarding the quantity of the 
nonfinancial commodity that may be needed or produced in the future, 
consistent with the purposes of a forward contract.\14\
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    \13\ See 77 FR 48228 (describing a forward contract as a 
``commercial merchandising transaction'' in which delivery is 
delayed for ``commercial convenience or necessity'').
    \14\ See 77 FR 48228 (``The primary purpose of a forward 
contract is to transfer ownership of the commodity and not to 
transfer solely its price risk.''). See also Letter from the 
Commodity Markets Council, the National Corn Growers Association, 
and the Natural Gas Supply Association (April 17, 2014) at 2 
(``[Contracts with volumetric optionality] exist to permit end-users 
to have agreements in place so that they can effectively and 
economically manage the purchase or sale of commodities related to 
their commercial businesses, not as a substitute for a financially 
settled contract or for speculative purposes.''); Letter from ONEOK, 
Inc. (July 22, 2011) at 7 (``Although the amounts that can be taken 
on delivery may vary, the primary intent of the contracts is not to 
provide price protection, which is clearly the intent of the 
contracts described in the [1985 CFTC] OGC Interpretation as trade 
options.'').
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    In response to commenters, the CFTC is proposing to modify the 
seventh element to further clarify its interpretation.\15\ To begin, 
the CFTC is proposing to remove reference to the ``exercise or non-
exercise'' of the embedded volumetric optionality. This language was 
included to embody the longstanding principle, recognized by 
commenters, that intent may be ascertained by the relevant facts and 
circumstances surrounding the contract, including the parties' course 
of performance thereunder.\16\ According to commenters, however, this 
language has created problems during contract negotiations, because 
certain parties feel pressure to specify the exact factors that could 
lead to the exercise or non-exercise of the volumetric optionality.\17\ 
By removing this language, the CFTC intends to clarify that the focus 
of the seventh element is intent with respect to the embedded 
volumetric optionality at the time of contract initiation.\18\ The CFTC 
would further advise commercial parties that they may rely on 
counterparty representations with respect to the intended purpose for 
embedding volumetric optionality in the contract, provided they are 
unaware, and should not reasonably have been aware, of facts indicating 
a contrary purpose.
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    \15\ As stated in the Products Release, the seventh element 
reads as follows:
    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.
    77 FR 48238 (footnotes omitted).
    \16\ See 77 FR 48228 (``In assessing the parties' expectations 
or intent regarding delivery, the CFTC consistently has applied a 
`facts and circumstances' test.''); Letter from ONEOK, Inc. (July 
22, 2011) at 6 (``The intent of the parties to defer delivery of a 
varying amount can be ascertained based on objective criteria, such 
as the pattern of deliveries in relation to variation in weather, 
customer demand, or other similar factors.'').
    \17\ See, e.g., Letter from the Commodity Markets Council, the 
National Corn Growers Association, and the Natural Gas Supply 
Association (April 17, 2014) at 2 & n.3 (stating that commercial 
parties are ``being asked for vague (and, therefore, potentially 
unenforceable) representations'' because ``the question of the 
reason for exercise of volumetric optionality can vary from 
transaction to transaction and is not known until the time of 
exercise''); Letter from the American Gas Association (April 17, 
2014) at 10 (citing ``widespread confusion as to whether 
counterparties must demonstrate forward contract status as of the 
time of entering into an agreement, or as of the time of exercise or 
non-exercise of delivery rights under the agreement.'').
    \18\ For example, in choosing whether to obtain additional 
supply by exercising the embedded volumetric optionality under a 
given contract or turning to another supply source--whether storage, 
the spot market, or another forward contract with embedded 
volumetric optionality--commercial parties would be able to consider 
a variety of factors, including price, provided that the intended 
purpose for including the embedded volumetric optionality in the 
contract at contract initiation was to address physical factors or 
regulatory requirements influencing the demand for or supply of the 
commodity.
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    The CFTC is also proposing to remove reference to physical factors 
or regulatory requirements being ``outside the control of the 
parties.'' This phrase was taken from commenter letters \19\ but has 
also apparently created problems during contract negotiations, as 
counterparties often disagree about the degree of control they have 
over factors influencing their demand for or supply of the nonfinancial 
commodity.\20\ By removing this language, the CFTC intends to clarify 
that whether the parties have some influence over factors affecting 
their demand for or supply of the nonfinancial commodity (e.g., the 
scheduling of plant maintenance, plans for business expansion) would 
not be inconsistent with the seventh element of the CFTC's 
interpretation, provided that the embedded volumetric optionality is 
included in the contract at initiation primarily to address potential 
variability in a party's supply of or demand for the nonfinancial 
commodity.
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    \19\ See Letter from BG Americas & Global LNG (July 22, 2011) at 
4 (``Variability associated with an energy customer's physical 
demand is influenced by factors outside the control of the energy 
suppliers (and sometimes the consumers) . . .''); Letter from the 
Working Group of Commercial Energy Firms (July 22, 2011) at 8 
(``Availability of production and requirements for consumption are 
often influenced by factors outside the control of the parties to an 
energy commodity transaction and can change on an hourly or daily 
basis.'') (emphasis added).
    \20\ Letter from the Plains All American Pipeline, L.P. (April 
17, 2014) at 3 (``[M]any counterparties understand the [seventh 
element] to have failed when a counterparty has more than one 
alternative to meet its physical commodity needs, therefore making 
the choice of supply `within its control.'''); Letter from the 
Commodity Markets Council, the National Corn Growers Association, 
and the Natural Gas Supply Association (April 17, 2014) at 2-3 
(listing as an issue stemming from the ambiguity in the seventh 
element ``uncertainty as to whether end-users with more than one 
supply choice are always exercising optionality within their 
control'').
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    The CFTC is also proposing to clarify that the phrase ``physical 
factors'' should be construed broadly to include any fact or 
circumstance that could reasonably influence supply of or demand for 
the nonfinancial commodity under the contract. Such facts and 
circumstances could 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.\21\ 
Concerns that are

[[Page 69076]]

primarily about price risk (e.g., expectations that the cash market 
price will increase or decrease), however, would not satisfy the 
seventh element absent an applicable regulatory requirement to obtain 
or provide the lowest price (e.g., the buyer is an energy company 
regulated on a cost-of-service basis).\22\
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    \21\ The CFTC reiterates that, as stated in the Products 
Release, system reliability issues that lead to voluntary supply 
curtailments would be considered ``physical factors'' within the 
scope of the seventh element. See 77 FR 48239 n.345.
    \22\ See Letter from the Office of the General Counsel, Federal 
Energy Regulatory Commission (Oct. 12, 2012) at 4. The CFTC confirms 
that, as stated in the Products Release, the deliverable quantities 
allowable under embedded volumetric optionality may be justified by 
a combination of regulatory requirements and physical factors, such 
that the quantity provided for by the embedded volumetric 
optionality may reasonably exceed quantities required by regulation. 
See 77 FR 48238 n.340.
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    The CFTC understands that in certain retail electric market demand-
response programs, electric utilities have the right to interrupt or 
curtail service to a customer to support system reliability.\23\ The 
CFTC is proposing to clarify that, given that a key function of an 
electricity system operator is to ensure grid reliability, demand 
response agreements, even if not specifically mandated by a system 
operator, may be properly characterized as the product of regulatory 
requirements within the meaning of the seventh element.\24\
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    \23\ See Letter from the National Rural Electric Cooperative 
Association, the American Public Power Association, the Large Public 
Power Association, and the Transmission Access Policy Study Group 
(Oct. 12, 2012) at 9.
    \24\ The CFTC clarifies that its interpretations regarding full 
requirements and output contracts, as provided in the Products 
Release, would be unaffected by the discussion herein. See 77 FR 
48239-40. Similarly, the CFTC reiterates that, depending on the 
relevant facts and circumstances, capacity contracts, transmission 
(or transportation) service agreements, tolling agreements, and 
peaking supply contracts, as discussed in the Products Release, may 
qualify as forward contracts with embedded volumetric optionality 
provided they meet the elements of the CFTC's proposed 
interpretation. See 77 FR 48240.
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III. Request for Comment

    The CFTC believes that it would benefit from public comment about 
its proposed interpretation, and therefore requests public comment on 
all aspects of its proposed interpretation regarding forwards with 
embedded volumetric optionality, and on the following questions:
    1. Market participants have expressed concerns about whether 
various types of volumetric optionality fit within the CFTC's 
interpretation. The CFTC recognizes that, since the interpretation is 
not intended to provide relief for all forms of embedded volumetric 
optionality, there are likely to remain concerns within the industry 
about the treatment of embedded volumetric optionality within forward 
contracts.
    The CFTC notes that, in April, 2012, the CFTC adopted an Interim 
Final Rule for Commodity Options (the ``IFR'').\25\ Even if a contract 
with volumetric optionality does not fit within the seven elements of 
the interpretation, the CFTC believes there is widespread agreement 
that contracts that fail one or more of the seven elements of the 
CFTC's interpretation would fall within the exemption from most swaps 
regulation provided by the IFR. Therefore, it appears that the IFR 
provides a clear and well-understood mechanism through which contracts 
with volumetric optionality can be exempted that avoids many of the 
difficulties of determining whether a particular contract with 
volumetric optionality would satisfy the seven elements of the CFTC's 
interpretation.
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    \25\ See 77 FR 25320 (April 27, 2012).
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    The CFTC invites comment on whether the IFR's approach to defining 
the universe of swaps subject to its exemption may provide a clearer 
and easier mechanism for providing relief from swaps requirements than 
the CFTC's interpretation of forwards with embedded volumetric 
optionality and whether the IFR currently provides sufficient relief 
for such contracts.
    2. Market participants have argued that the lack of clarity around 
the seventh element of the CFTC's interpretation has led to costs to 
end-users. Conceivably, since contracts that fail one or more of the 
seven elements would be regulated as exempt commodity trade options 
under the IFR, these costs are attributable to complying with the IFR. 
The CFTC invites comment on whether or not this is the case, and 
invites the submission of data quantifying those costs.
    3. What factors should the CFTC consider in determining whether the 
proposed modifications and clarifications to the CFTC's interpretation 
are appropriate in view of CFTC precedent regarding the interpretation 
of the CEA's forward contract exclusion? Do the proposed changes 
provide sufficient clarity on how contracts with embedded volumetric 
optionality may satisfy all seven elements of the interpretation, 
particularly the first and second elements? Are there reasons why 
trying to provide further relief through the swap definition's forward 
contract exclusion would not be in the public interest?

    By the Securities and Exchange Commission.
Brent J. Fields,
Secretary.
    Dated: November 13, 2014.

    Issued in Washington, DC, on November 13, 2014, by the Commodity 
Futures Trading Commission.
Christopher J. Kirkpatrick,
Secretary of the Commission.

Commodity Futures Trading Commission (CFTC) Appendices to Forward 
Contracts With Embedded Volumetric Optionality--Commission Voting 
Summary, Chairman's Statement, and Commissioners' Statements

Appendix 1--Commodity Futures Trading Commission Voting Summary

    On this matter, Chairman Massad and Commissioners Wetjen, Bowen, 
and Giancarlo voted in the affirmative. No Commissioner voted in the 
negative.

Appendix 2--Statement of CFTC Chairman Timothy G. Massad

    I support the Staff's proposed interpretation regarding forward 
contracts that have what is known as embedded volumetric 
optionality--generally speaking, contracts to buy or sell a 
nonfinancial commodity for deferred delivery that provide for 
variations in delivery amount.
    One of my priorities has been to fine-tune our rules to make 
sure they work as intended and do not impose undue burdens or 
unintended consequences, particularly for the nonfinancial 
commercial businesses that use these markets to hedge commercial 
risks. We must make sure these businesses--whether they are 
manufacturers, farmers, ranchers or other companies--can continue to 
use these markets efficiently and effectively.
    This proposal is part of that effort. In certain situations, 
commercial parties are unable to predict at the time a contract is 
entered into the exact quantities of the commodity that they may 
need or be able to supply, and the embedded volumetric optionality 
offers them the flexibility to vary the quantities delivered 
accordingly. The CFTC put out an interpretation, consisting of seven 
factors, to provide clarity as to when such contracts would fall 
within the forward contract exclusion from the swap definition, but 
some market participants have felt this interpretation, in 
particular the seventh factor, was hard to apply. In some cases, the 
two parties would reach different conclusions about the same 
contract.
    Today we are proposing clarifications to the interpretation that 
I believe will alleviate this ambiguity and allow contracts with 
volumetric optionality that truly are intended to address 
uncertainty with respect to the parties' future production capacity 
or delivery needs, and not for speculative purposes or as a means to 
obtain one-way price protection, to fall within the exclusion.

[[Page 69077]]

Appendix 3--Statement of CFTC Commissioner Mark P. Wetjen

    This proposal further clarifying the definition of forward 
contracts with embedded volumetric optionality, or EVO, is intended 
to provide commercial firms the regulatory clarity they have sought 
since the original release of the seven-part test in August 2012.
    The definition of a swap in the Commodity Exchange Act includes 
commodity options, but excludes from that definition forward 
contracts.\26\ There was a policy reason for this, and at its root 
was a desire to ensure that Dodd-Frank captured many swaps, and 
swap-like contracts, that were structured to be similar to options, 
while also ensuring that a new regulatory regime was not 
inadvertently and inappropriately extended into certain physical 
markets.
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    \26\ 7 U.S.C. 1a(47).
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    The broad definitional language in question was designed to 
ensure that financial--as opposed to physical--contracts could not 
be structured or re-characterized to avoid the new market structure. 
While the swap definition does not expressly exclude options on 
energy and agricultural commodities, it does exclude both futures 
and forwards. I am confident Congress did not intend to pull 
contracts that historically have been treated as forwards into the 
new swap regime solely because of optionality in the amount of the 
physical commodity delivered under the contract.
    As a policy matter, Congress surely recognized that the swap 
definition had to reflect a long-held Commission belief that 
contracts that are physically settled, and where delivery is 
required, do not pose the same systemic threats to the financial 
system as contracts used for speculative purposes. Moreover, 
Congress expanded the Commission's fraud \27\ and anti-manipulation 
authority \28\ over markets where forward contracts are traded, and 
left intact the Commission's surveillance authority to issue special 
calls to market participants for all positions and transactions 
related to a commodity.\29\
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    \27\ 7 U.S.C. 9(c)(1) (``It shall be unlawful for any person, 
directly or indirectly, to use or employ, or attempt to use or 
employ, in connection with . . . a contract of sale of any commodity 
in interstate commerce . . . any manipulative or deceptive device or 
contrivance, in contravention of such rules and regulations as the 
Commission shall promulgate . . .''.). See also 17 CFR Part 180.
    \28\ 7 U.S.C. 9(c)(3) (``[I]t shall be unlawful for any person, 
directly or indirectly, to manipulate or attempt to manipulate the 
price . . . of any commodity in interstate commerce. . .'').
    \29\ 17 CFR 18.05(b) (maintenance of books and records 
concerning positions and transactions in the cash commodity); 17 CFR 
1.31 (pursuant to Sec.  1.31(2), the authority to request 
information required to be kept in accordance with the Act or 
Commission regulations); 17 CFR 1.35 (pursuant to Sec.  1.35(3), the 
authority to request from a futures commission merchant, retail 
foreign exchange dealer, introducing broker or member of a 
designated contract market or swap execution facility records 
required to be kept by Sec.  1.35 in accordance with the 
requirements of Sec.  1.31); 17 CFR 23.203 (pursuant to Sec.  
23.203(a), the authority to request and receive within 72 hours any 
records required to be kept by a swap dealer or major swap 
participant by the Act and by Commission regulations and pursuant to 
Sec.  23.203(2), the authority to request records of any swap or 
related cash or forward transaction); 17 CFR 23.606 (pursuant to 
Sec.  23.606(c), the authority to request information that a swap 
dealer or major swap participant is required to maintain under Sec.  
23.606(a)(1)); 17 CFR 45.2 (pursuant to Sec.  45.2(h), the authority 
to request from swap execution facilities, designated contract 
markets, derivatives clearing organizations, swap dealers, and major 
swap participants records required to be kept pursuant to Sec.  
45.2.); 17 CFR 46.2 (the authority, pursuant to Sec.  46.2(e), to 
request records relating to pre-enactment and transition swaps in 
existence on or after April 25, 2011).
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    As mentioned, in resolving to adopt the appropriate regulatory 
treatment of forward contracts with EVO, the Commission also must 
weigh the operational and compliance consequences of that treatment. 
Indeed, the Commission should bring a heightened sensitivity to 
these considerations in the context of the power sector because 
affordable electricity and heat are such fundamental needs of modern 
life.
    The Commission's 2012 interpretation, while intended to be 
helpful, contained certain ambiguities in the seven-part test that 
created confusion among commercial end-users.
    Last spring, the Commission learned at a public roundtable that 
some market participants may have withdrawn from the market due to 
those ambiguities, resulting in inferior execution for commercial 
firms. It is difficult to measure the exact impact of this 
phenomenon, but apparently it has not been a positive one for 
consumers of electricity and gas.

A. Ambiguity in the Seven-Part Test

    In discussing the seven-part test, commentators zeroed in on two 
primary issues. First, many of the roundtable participants noted 
that the exercise or non-exercise of volumetric optionality depends 
on a number of factors,\30\ some of which will be outside of the 
control of the parties, and some that will not.
---------------------------------------------------------------------------

    \30\ Letter from The Edison Electric Institute (``EEI'') and the 
Electric Power Supply Association (``EPSA'') (April 17, 2014) 
(``EEI/EPSA Letter'') at 3 (``The exercise or non-exercise of 
volumetric optionality under a forward energy contract depends on a 
number of factors, including but not limited to, any or all of the 
following: (1) The level of demand as affected by weather or market 
conditions; (2) the amount of unexercised volume remaining under the 
contract; (3) the time of the change in the level of demand relative 
to delivery scheduling capabilities, (4) anticipated future weather 
conditions, (5) the delivery location under the contract relative to 
the demand location; (6) the price and availability of 
transportation capacity (e.g. pipeline capacity) to move natural 
gas; (7) the price of alternative sources of supply; (8) the 
availability of natural gas or electricity in the spot market; and/
or (9) the remaining inventory of the commodity in storage.'').
---------------------------------------------------------------------------

    Many also noted that parties could reasonably disagree on 
whether, and the degree to which, a factor is outside of the control 
of the parties. For example, having choice among more than one 
source of supply, or selecting from those choices the lowest-priced 
contract, to some commercial firms caused the contract to fail the 
seventh prong.
    This ambiguity contributed to a second issue--market 
participants stated that they often do not know the exact reasons 
that optionality will be exercised until the time of exercise. In 
other words, parties are uncertain how to characterize contracts at 
the time of execution, and how intent at the time of exercise or 
non-exercise might affect that analysis.\31\
---------------------------------------------------------------------------

    \31\ Letter from the American Gas Association (April 17, 2014) 
(``AGA Letter'') at 10 (citing ``widespread confusion as to whether 
counterparties must demonstrate forward contract status as of the 
time of entering into an agreement, or as of the time of exercise or 
non-exercise of delivery rights under the agreement.'').
---------------------------------------------------------------------------

    The seventh factor's ambiguity has caused a host of problems. 
For instance, parties have been asked to provide vague and possibly 
unenforceable representations in agreements.\32\ Parties also often 
disagree about the proper categorization of a transaction, resulting 
in them ``agreeing to disagree'' and considering the same 
transaction to be, at the same time, a swap, trade option, or a 
forward with EVO.\33\ This has had the unintended consequence of 
distorting transaction data reported to the Commission.\34\
---------------------------------------------------------------------------

    \32\ AGA Letter at 2; EEI/EPSA letter at 3.
    \33\ NFP Electric Associations Letter at 3.
    \34\ EEI/EPSA letter at 3.
---------------------------------------------------------------------------

    The bottom line is that such uncertainty in the seven-part test 
increased transaction costs for commercial firms and limited their 
access to an effective risk-management tool.

B. Proposed Clarifications

    This proposal appropriately modifies and clarifies the 
interpretation of the seventh prong. First, it clarifies that 
concluding whether the seventh prong is met should be determined by 
looking to the intent of the parties at the outset of contract 
initiation.
    Second, the new proposal also deletes language referring to 
physical or regulatory factors being ``outside of the control of the 
parties.'' Deleting this ambiguous language helps clarify that 
parties having some influence over factors affecting their demand 
for a nonfinancial commodity will not per se cause a contract to 
fail the seventh prong.
    In that vein, the proposal also notes that parties may take a 
variety of factors into consideration when determining whether to 
exercise volumetric optionality, so long as the intended purpose was 
to address physical factors or regulatory requirements influencing 
the demand for, or supply of, the commodity.
    Prongs one through six of the test are also appropriately 
crafted to ensure that the EVO does not undermine the forward 
contract's overall purpose. Prongs two and three help achieve those 
purposes by requiring the predominant factor to be actual delivery, 
and prohibiting the embedded optionality from being severed and 
marketed separately from the overall agreement.
    Prongs four and five also help deter the potential for abuse of 
these contracts by requiring that the seller under the contract 
intends to deliver, and the buyer intends to receive, the underlying 
commodity.
    This proposal should go a long way towards providing commercial 
firms

[[Page 69078]]

adequate guidance, but I look forward to comments on whether it is 
adequate enough.

Appendix 4--Concurring Statement of CFTC Commissioner Sharon Y. Bowen

    This is a proposal that, I am concerned, will neither provide 
the clarity industry is seeking regarding the treatment of embedded 
volumetric options nor the safeguards that Congress intended when it 
passed the Dodd-Frank Wall Street Reform and Customer Protection 
Act.
    I do not oppose the Commission's trying to better tailor our 
regulations to address concerns of end-users. In fact, I commend the 
Chairman and my fellow Commissioners for trying to address the 
issues that have arisen from our existing guidance and rules on 
embedded volumetric options. After many meetings with stakeholders 
and much analysis of this subject, I am convinced that the 
Commission should address concerns that industry has raised 
regarding the treatment of embedded volumetric options.
    However, the proposed interpretation may not resolve the issues 
industry has raised. Options, even physical options, have never been 
interpreted by the Commission to be forward contracts. They lack the 
central characteristic that is critical to being a forward contract 
under the Commodity Exchange Act: A binding obligation to deliver at 
some time in the future. The history on this is clear, if there is 
no binding obligation to deliver, there is no forward contract.
    The seventh factor was intended, essentially, as a ``safe-
harbor'' provision. Notwithstanding the fact there is no obligation 
to make or take delivery for the optional portion of the specified 
commodity, the seventh factor was designed to allow a party's 
transaction to receive the forward exclusion if that party can 
demonstrate that it determined the specified, optional amount was 
necessary based upon commercial and physical factors, and exercised 
the option based upon those factors. In other words, this seventh 
factor was designed to allow embedded volumetric options to receive 
the forward contract exclusion treatment where their exercise was 
driven largely by external commercial and physical factors central 
to the party's commercial business, but largely beyond the control 
of the party. Through its conduct then, the party was demonstrating 
its intent to be ``bound'' to exercise the option if its estimate, 
based on the factors it used, proved to be accurate.
    The Commission was trying to distinguish such a situation from a 
situation where the party enters into the embedded volumetric option 
intending to exercise the volumetric option based upon whether, at 
the time of exercise, it still makes economic sense to use the 
option. In other words, it was trying to distinguish a situation 
where the motivation for exercising the option was primarily or 
substantially based on price. In the latter case, the embedded 
volumetric option is hard to distinguish, in usage, from any other 
commodity option. There is no demonstration in the party's course of 
conduct that it intended to be ``bound'' to exercise the option at 
all.
    While this test is far from perfect, and I can see the 
difficulty industry would have in administering it, the Commission 
was clearly trying to find a rationale for allowing some volumetric 
optionality that was consistent with the Commission's historic 
treatment of forward contracts, while avoiding completely erasing 
the line between options and futures on the one hand, and cash and 
forward contracts on the other.
    This current proposal, however, in possibly broadening the 
universe of options that would fit within the seventh factor, seems 
to depart from that rationale, and in doing so, loses that vital 
element of demonstrating the parties intended to be ``bound'' in 
some sense to exercise the option and consequently that the option 
was similar, in usage, to a forward contract. Without that, it is 
not clear to me how such an option can be considered consistent with 
a forward contract. If it cannot be considered at least similar to a 
forward contract, I am not sure how a party would determine that 
embedding such an option in a forward contract would not undermine 
its nature as a forward contract and thus fail the first factor of 
the seven-factor test.
    There is nothing in the Commodity Exchange Act or Dodd-Frank 
that contemplates options can be deemed forward contracts simply by 
being associated with a forward contract. In fact, the opposite 
seems true: Congress specifically determined that commodity options 
are swaps and removed the Commission's ability to provide exemptions 
from the definition of swap.
    Interestingly though, Congress did maintain the Commission's 
authority to determine how swaps that are commodity options should 
be regulated since Congress did not repeal the Commission's plenary 
authority over options, including options that are swaps. It was 
that plenary authority that the Commission utilized to exempt trade 
options from most of the regulations applicable to swaps in April 
2012. It is that authority that the Commission should use here to 
address embedded volumetric options.
    By seeking to broaden an exclusion for volumetric options 
embedded in forward contracts, the proposed interpretation does try 
to achieve a goal that industry apparently wants--they would like 
these options to be outside the Commission's jurisdiction rather 
than just exempted from regulation. However, history has shown that 
as the circle of exclusion widens for industry, too often the circle 
of protection narrows for investors and consumers.
    In 1993, one Commissioner cast the lone dissenting vote against 
exempting over-the-counter energy derivatives from Commission 
regulation. She argued that exempting energy derivatives from 
regulation would set a dangerous precedent and would leave the 
public unprotected. Today's proposal seems to go farther. It 
excludes embedded volumetric options from the Commission's 
authority. Whereas with an exemption, there is the ability to later 
tailor it to fit the precise needs of the market and the public, 
there is no turning back from an exclusion.
    Congress said, quite clearly, that commodity options are swaps, 
not forwards. Embedded volumetric options should be exempted as 
options, not excluded as forwards. I know many in industry have 
spoken for the need for further clarity regarding the regulation of 
embedded volumetric options. I don't know what clarity is achieved 
by trying to call something what it is not. If it looks like an 
option, is used like an option, and works like an option, it is most 
likely, an option.
    I think the objective of providing for clear regulatory 
treatment of embedded volumetric options will be far easier to 
implement, and far more complete, if done through fixing the trade 
option exemption. Regardless, this proposal is the vehicle before 
the Commission at present. I want us to get this interpretation 
right, and therefore support getting public comment on these 
changes. I do not believe we should contemplate such a significant 
change to our jurisdiction without receiving the public's views on 
it first. I invite all interested stakeholders to respond to this 
proposal and look forward to reviewing their comments.

[FR Doc. 2014-27285 Filed 11-19-14; 8:45 am]
BILLING CODE 6351-01-P; 8011-01-P


