
[Federal Register Volume 80, Number 95 (Monday, May 18, 2015)]
[Notices]
[Pages 28239-28244]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2015-11946]


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COMMODITY FUTURES TRADING COMMISSION

RIN 3038-AE24

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-74936; File No. S7-16-11]
RIN 3235-AK65


Forward Contracts With Embedded Volumetric Optionality

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

ACTION: Final interpretation.

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SUMMARY: In accordance with section 712(d)(4) of the Dodd-Frank Wall 
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[[Page 28240]]

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 clarification of its interpretation 
concerning forward contracts with embedded volumetric optionality.

DATES: This interpretation is effective on May 18, 2015.

FOR FURTHER INFORMATION CONTACT: CFTC: Elise Pallais, Counsel, (202) 
418-5577, epallais@cftc.gov; Mark Fajfar, Assistant General Counsel, 
(202) 418-6636, mfajfar@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 options \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). As described in 
the Products Release, the interpretation included the following 
seven elements:
    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.
    \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'') (emphasis added).
    \3\ See 77 FR at 48238-42 & n.335. As explained in the Products 
Release, the CFTC interprets the exclusions in CEA sections 
1a(47)(B)(ii) and 1a(27) as coextensive and thus requiring a 
consistent interpretation. See id. at 48227-8. See also id. at 
48227-36 (discussing 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 * * *''). CEA section 1a(47)(A)(i) does not 
differentiate between financially- and physically-settled options. 
Certain physically-settled options, termed ``trade options,'' are 
nevertheless exempt from most requirements applicable to swaps. See 
17 CFR 32.3. Additionally, the CFTC is proposing to amend its trade 
option exemption to further reduce the reporting and recordkeeping 
requirements applicable to certain commercial end users. See Trade 
Options, 80 FR 26200 (May 7, 2015).
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    In response to requests from market participants,\6\ the CFTC 
proposed in November 2014 to clarify its interpretation of when an 
agreement, contract, or transaction with embedded volumetric 
optionality would be considered a forward contract.\7\ In particular, 
the CFTC proposed to (a) modify the fourth and fifth elements of its 
interpretation to clarify that the interpretation applies to embedded 
volumetric optionality in the form of both puts and calls \8\ and (b) 
modify the seventh element to clarify that the embedded volumetric 
optionality must be primarily intended, at the time 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.\9\ The CFTC requested 
comment on all aspects of its proposal.\10\
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    \6\ The Products Release included a request for comment on the 
CFTC's interpretation regarding forward contracts with embedded 
volumetric optionality. See 77 FR at 48241-42. CFTC staff also 
solicited comments in connection with a public roundtable on 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. In general, 
commenters asserted that uncertainty with regard to the CFTC's 
interpretation, particularly the seventh element, has led to 
confusion over whether to characterize certain transactions as 
excluded forward contracts with embedded volumetric optionality or 
regulated trade options.
    \7\ Forward Contracts With Embedded Volumetric Optionality, 79 
FR 69073 (Nov. 20, 2014) (the ``Proposed Interpretation''). Section 
712(d)(4) of the Dodd-Frank Act 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 requires this 
interpretation, which was originally included in the Products 
Release, to be issued jointly by the CFTC and the SEC, it is an 
interpretation solely of the CFTC and does 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.
    \8\ Id. at 69074.
    \9\ Id. at 69074-76.
    \10\ See id. at 69076. The CFTC also requested comment in 
response to specific questions relating to its proposal. Id. The 
comment file, which includes 22 unique comments and one (1) ex parte 
communication, is available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1541. Commenters include American 
Gas Association; American Petroleum Institute; American Public Power 
Association, Edison Electric Institute, Electric Power Supply 
Association, Large Public Power Council, and National Rural Electric 
Cooperative Association; Americans for Financial Reform; Barnard, 
Chris; Better Markets Inc.; Business Council for Sustainable Energy; 
Coalition for Derivatives End-Users; Coalition of Physical Energy 
Companies; Cogen Technologies Linden Venture LP; Commercial Energy 
Working Group and Commodity Markets Council; Dairy Farmers of 
America; EDF Trading North America LLC; Federal Energy Regulatory 
Commission staff; Fig, Willem; International Energy Credit 
Association; International Swaps and Derivatives Association Inc.; 
National Association of Manufacturers; National Corn Growers 
Association and Natural Gas Supply Association; National Energy 
Marketers Association; Public Citizen; and Southern Company Services 
Inc., acting on behalf of and as agent for Alabama Power Co., 
Georgia Power Co., Gulf Power Co., Mississippi Power Co., and 
Southern Power Co. None of the commenters requested any revisions to 
SEC rules or regulations (or interpretations thereof), but rather 
addressed issues relating solely to the CFTC's interpretation.

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[[Page 28241]]

II. Overview

    After a careful review of the comments received, the CFTC has 
determined to finalize its interpretation as proposed with some 
additional clarifications. Accordingly, 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:
    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.
    As stated in the Proposed Interpretation, the first six elements of 
this interpretation are largely unchanged from the Products 
Release.\11\ Among them, only the fourth and fifth elements have been 
modified, as proposed, to clarify that the CFTC's interpretation 
applies to embedded volumetric optionality in the form of both puts and 
calls.\12\ Accordingly, the CFTC's discussion of these six elements in 
the Products Release remains relevant and applicable.\13\ The seventh 
element of the interpretation is discussed further below.
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    \11\ See 77 FR at 48238.
    \12\ 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 at 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).
    \13\ See 77 FR at 48238-39.
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    As a general matter, the CFTC clarifies that its interpretation 
with respect to forward contracts with embedded volumetric optionality 
should not be read to alter or expand the historic interpretation of 
the forward contract exclusion. As the first two elements affirm, the 
interpretation presupposes the existence of an underlying forward 
contract, as determined by applying the historic interpretation of the 
forward contract exclusion.\14\ The CFTC's interpretation, as provided 
herein, merely identifies the circumstances under which volumetric 
optionality embedded in such a forward contract would not operate to 
take the contract outside the forward contract exclusion.\15\ As 
explained in the Products Release, the historic interpretation of the 
forward contract exclusion remains relevant and applicable.\16\
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    \14\ See id. at 48227-36.
    \15\ The CFTC's interpretation only addresses when a forward 
contract with embedded volumetric optionality would be excluded from 
the swap or future delivery definitions in the CEA; it does not 
address whether a contract would otherwise fall within the swap 
definition. In other words, a contract that does not meet one or 
more elements of the CFTC's interpretation may or may not be a swap 
depending on the characteristics of the contract. See, e.g., id. at 
48246-52 (discussing application of the swap definition to consumer 
and commercial agreements).
    \16\ See, e.g., id. at 48228.
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    In response to commenters, the CFTC clarifies that the fourth and 
fifth elements of the interpretation do not preclude bandwidth (a.k.a. 
``swing'') contracts, which provide for delivery of a nonfinancial 
commodity within a certain minimum and maximum range, from falling 
within the forward contract exclusion from the swap and future delivery 
definitions.\17\ As indicated in the Products Release, the fourth and 
fifth elements merely require that the intent to make or take delivery 
(as applicable) required of the underlying forward contract extends to 
the embedded volumetric optionality, such that both parties to the 
contract intend to make or take delivery (as applicable) of the 
nonfinancial commodity under the contract if the embedded volumetric 
optionality is exercised.\18\ The embedded volumetric optionality may 
therefore operate to increase and/or decrease the quantity delivered 
under the underlying forward contract and still not take the contract 
out of the forward exclusion provided that all elements of the CFTC's 
interpretation, as provided herein, are satisfied.
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    \17\ See Letter from Coalition of Physical Energy Companies 
(Dec. 22, 2014) at 4; Letter from Commercial Energy Working Group 
and Commodity Markets Council (Dec. 22, 2014) at 3-4; Letter from 
EDF Trading North America LLC (``EDFTNA'') (Dec. 22, 2014) at 15-17; 
Letter from International Energy Credit Association (``IECA'') (Dec. 
22, 2014) at 4-5; Letter from International Swaps and Derivatives 
Association Inc. (Dec. 22, 2014) at 3 (each requesting clarification 
that the fourth and fifth elements permit both increases and 
decreases in volume).
    \18\ See 77 FR at 48239 (``The fourth and fifth elements are 
designed to ensure that both parties intend to make or take delivery 
(as applicable), subject to the relevant physical factors or 
regulatory requirements, which may lead the parties to deliver more 
or less than originally intended.'') (emphasis added).
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III. The Seventh Element

    As stated in the Proposed Interpretation, the seventh element 
addresses the primary reason for including embedded volumetric 
optionality in a forward contract.\19\ Embedded volumetric optionality 
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.\20\ The seventh element ensures that this purpose, 
consistent with the historical interpretation of a forward 
contract,\21\ 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.\22\
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    \19\ See 79 FR at 69074-75.
    \20\ See, e.g., Letter from the Commodity Markets Council, the 
National Corn Growers Association, and the Natural Gas Supply 
Association (``CMC/NCGA/NGA'') (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.'').
    \21\ See 77 FR 48228 (describing a forward contract as a 
``commercial merchandising transaction'' in which delivery is 
delayed for ``commercial convenience or necessity'').
    \22\ See 77 FR at 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 CMC/
NCGA/NGA (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 (stating 
that ``[a]lthough the amounts that can be taken on delivery may 
vary, the primary intent of the contracts is not to provide price 
protection'').

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    As indicated in the Proposed Interpretation, the focus of the 
seventh element is the intent of the party with the right to exercise 
the embedded volumetric optionality at the time of contract 
initiation.\23\ In line with the CFTC's historical interpretation of 
the forward contract exclusion, as discussed in the Products Release, 
such intent may be ascertained by the relevant facts and circumstances 
surrounding the contract, including the parties' course of performance 
thereunder.\24\ Nevertheless, commercial parties may rely on 
counterparty representations with respect to the intended purpose for 
embedding volumetric optionality in the contract provided they do not 
have information that would cause a reasonable person to question the 
accuracy of the representation. In response to commenters, the CFTC 
clarifies that commercial parties are not required to conduct due 
diligence in order to rely on such representations.\25\
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    \23\ 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. See also Letter from EDFTNA (Dec. 22, 2014) at 20 
(requesting further clarification that the seventh element only 
addresses the intent of the party with the right to exercise the 
embedded volumetric optionality.)
    \24\ See 77 FR 48228 (``In assessing the parties' expectations 
or intent regarding delivery, the CFTC consistently has applied a 
`facts and circumstances' test.''). For example, if one party has an 
option to settle a contract financially based upon a value change in 
an underlying cash market, then the contract may be a swap. See id. 
at 48241 n. 370. See also Letter from ONEOK, Inc. (July 22, 2011) at 
6 (acknowledging that ``[t]he 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.'').
    \25\ See Letter from EDFTNA (Dec. 22, 2014) at 22-23 (arguing 
that requiring counterparties to conduct due diligence in order to 
ensure that facts suggesting an alternate purpose for the embedded 
volumetric optionality are not present would be ``infeasible'' and 
may undercut the utility of the Proposed Interpretation).
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    The CFTC clarifies that the seventh element's reference to 
``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.\26\ The 
CFTC further clarifies that the parties' having some influence over 
such physical factors (e.g., the scheduling of plant maintenance, plans 
for business expansion) would not be inconsistent with the seventh 
element, 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, consistent with the purposes of a forward contract.
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    \26\ 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 at 48239 n.345.
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    The CFTC reiterates, however, that if the embedded volumetric 
optionality is primarily intended, at contract initiation, to address 
concerns about price risk (e.g., to protect against increases or 
decreases in the cash market price), the seventh element would not be 
satisfied absent an applicable regulatory requirement, including 
guidance, whether formal or informal, received from a public utility 
commission or other similar governing body, to obtain or provide the 
lowest price (e.g., the buyer is an energy company regulated on a cost-
of-service basis).\27\ The CFTC recognizes that, as commenters have 
pointed out, price is likely to be a consideration when entering into 
any contract, including a forward contract.\28\ However, to ensure 
that, as required by the first element, the overall nature of the 
contract as a forward is not undermined,\29\ the embedded volumetric 
optionality must, as stated above, be primarily intended as a means of 
securing a supply source in the face of uncertainty (arising from 
physical factors or regulatory requirements, such as an obligation to 
ensure system reliability) regarding the volume of the nonfinancial 
commodity to be needed or produced.\30\
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    \27\ The CFTC confirms that, as stated in the Proposed 
Interpretation and 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 at 48238 n.340.
    \28\ See 77 FR at 48228 (``The primary purpose of a forward 
contract is to transfer ownership of the commodity and not to 
transfer solely its price risk.'') (emphasis added). See also Letter 
from American Gas Association (``AGA'') (Dec. 22, 2014) at 8-10; 
Letter from Coalition for Derivatives End-Users (Dec. 22, 2014) at 
6; Letter from American Public Power Association, Edison Electric 
Institute, Electric Power Supply Association, Large Public Power 
Council, and National Rural Electric Cooperative Association 
(``Joint Associations'') (Dec. 22, 2014) at 4-5; Letter from 
Southern Company Services Inc., acting on behalf of and as agent for 
Alabama Power Co., Georgia Power Co., Gulf Power Co., Mississippi 
Power Co., and Southern Power Co. (Dec. 22, 2014) at 2-3.
    \29\ See 77 FR at 48227-36.
    \30\ See 1985 CFTC OGC Interpretation, 50 FR at 39658. But see 
supra note 23; Letter from National Corn Growers Association and 
Natural Gas Supply Association (Dec. 22, 2014) (recognizing that 
price concerns are acceptable ``if they arise subsequent to 
execution or are motivated by an applicable regulatory 
requirement'').
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    Additionally, as stated in the Proposed Interpretation, 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.\31\ The CFTC 
clarifies 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.\32\
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    \31\ 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.
    \32\ The CFTC further clarifies that its interpretations 
regarding full requirements and output contracts, as provided in the 
Products Release, remain relevant and unaffected by the discussion 
herein. See 77 FR at 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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    Finally, in response to requests from commenters, the CFTC 
clarifies that commercial parties may choose to either rely on their 
good faith characterization of an existing contract (e.g., as an 
excluded forward contract with embedded volumetric optionality or an 
exempt trade option) and or recharacterize it in accordance with this 
final interpretation.\33\
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    \33\ Letter from AGA (Dec. 22, 2104) at 12, 19 (requesting 
relief for market participants who reported transactions as trade 
options that, following adoption of the Proposed Interpretation, 
they would consider excluded forwards); Letter from EDFTNA (Dec. 22, 
2014) at 5-7 (arguing that reassessment of the legal character of an 
existing contract is impractical) Letter from IECA (Dec. 22, 2014) 
at 3 (arguing that requiring parties to reclassify their existing 
contracts following adoption of the Proposed Interpretation would be 
unduly burdensome); Letter from Joint Associations (Dec. 22, 2014) 
at 11 (requesting that the CFTC allow counterparties to reclassify 
their transactions following adoption of the Proposed 
Interpretation).

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[[Page 28243]]

    The CFTC believes that these modifications are appropriately 
measured to clarify the meaning of certain language in the seventh 
element and should not be construed as a shift in the CFTC's 
longstanding precedent on the difference between forward contracts and 
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options.

    By the Securities and Exchange Commission.

     Dated: May 12, 2015.
Brent J. Fields,
Secretary.
    Issued in Washington, DC, on May 12, 2015, 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 Commissioner's Statement

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 Support of CFTC Chairman Timothy G. Massad

    I support the staff's recommendations to finalize a proposal we 
made in November regarding contracts with embedded volumetric 
optionality--a contractual right to receive more or less of a 
commodity at the negotiated contract price.
    As I said in my statement on the proposal, with reforms as 
significant as these, it is inevitable that there will be a need for 
some minor adjustments. And that is what we are doing. The changes 
we are proposing today help ensure that as we regulate the potential 
for excessive risks in these markets, we make sure that the 
commercial businesses--whether they are farmers, ranchers, 
manufacturers or others--that rely on these markets to hedge routine 
risks can continue to do so efficiently and effectively.
    Specifically, we proposed to clarify when a contract with 
embedded volumetric optionality will be excluded from being 
considered a swap. We received a number of comments on this and we 
have incorporated some of the concerns in the final clarification. 
Today, following action by the SEC last week, we are posting to the 
Federal Register the final interpretation. By clarifying how these 
agreements will be treated for regulatory purposes, the 
interpretation should make it easier for commercial companies to 
continue to use these types of contracts in their daily operations.
    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 finalizing 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.

Appendix 3--Concurring Statement of CFTC Commissioner Sharon Y. Bowen

    Today we are approving a final interpretation regarding forward 
contracts with embedded optionality. This interpretation is improved 
compared to the proposed interpretation and I am voting in favor of 
it. However, I am concerned that this interpretation does not 
provide the clarity that may be required.
    Staff has done a remarkable job in considering the comments 
received and drafting this final interpretation and they deserve 
ample praise for their hard work. Yet, staff, and this Commission, 
face statutory restrictions regarding the definitions of forwards 
and options that place limits on the relief available through 
interpretations of the forward contract exclusion. There is no 
interpretation, by this Commission or its staff, which can turn an 
option into a forward.
    Given the interpretive questions about the final rule defining 
``swap'' and the difficulties in classifying forward contracts with 
embedded optionality, I think it is important to be clear on what 
this interpretation can and cannot do--I do not want people to make 
business decisions based upon a mistaken belief that they have 
received relief when they have not.
    The central issue industry faces is that, in the manufacturing, 
agriculture and energy sectors, a wide variety of physically-
delivered instruments are used to secure companies' commercial needs 
for a physical commodity. These instruments often contain elements 
of both a forward contract and a commodity option. These contracts, 
particularly in the energy sector, are all commonly referred to as 
physical contracts, and they, according to what I have been told, 
often receive similar treatment from both a business operations and 
an accounting standpoint within the entities that use them.
    Furthermore, my understanding is that these physical contracts 
are often handled and accounted for separately from other 
derivatives, such as futures contracts or cash-settled swaps. 
Treating some portion of these physical contracts as swaps simply 
because they may contain some characteristics of commodity options 
can lead to significant costs and difficulties. For instance, 
companies may have to reconfigure their business systems to parse 
transactions where there was, before Dodd Frank, no need to 
undertake such a reconfiguration.
    I have studied this issue closely, meeting with industry and the 
public and reviewing the comments we have received. In the case of 
these transactions which are used to address physical commodity 
needs, I have doubts about whether any public interest is served by 
requiring manufacturing, agricultural and energy companies to 
undertake such a burden and reconfigure processes to comply with 
Commission swap regulations.
    The limits on relief through this interpretation flow from the 
statutory lines drawn between options and forward contracts. Under 
the CEA, options and forwards are discrete, mutually exclusive 
categories. Options are subject to the Commission's plenary, 
exclusive jurisdiction. Forward contracts, on the other hand, are 
almost entirely excluded from the Commission's jurisdiction. If a 
contract, or some portion of a contract, meets the definition of an 
``option,'' that portion which is an option inherently cannot be a 
forward contract.
    Under the CEA, a critical difference between a physically-
delivered option and a forward contract is the nature of the 
delivery obligation. A forward contract binds both parties to make 
and take delivery of a commodity at some date in the future. The 
contract may only be offset through a separate negotiation of the 
parties. In a physically-settled option contract, only the party 
offering the option is bound to make or take delivery at the time of 
contract.
    The forward contract exclusion from the swap definition, applies 
only to a ``[A] sale of a nonfinancial commodity or security for 
deferred shipment or delivery, so long as the transaction is 
intended to be physically settled.'' The key part of this definition 
is that it only applies to a ``sale'' of a commodity. A ``sale'' 
means that one party has agreed to make and the other to take 
delivery of that commodity.\1\
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    \1\ The phrase, ``so long as the transaction is intended to by 
physically settled,'' has been interpreted by the Commission to be 
consistent with its traditional approach to determining whether an 
instrument is a forward contract. As was stated in the Commission's 
proposed rule,
    The CFTC believes that the forward contract exclusion in the 
Dodd-Frank Act with respect to nonfinancial commodities should be 
read consistently with th[e] established, historical understanding 
that a forward contract is a commercial merchandising transaction.
    Many commenters discussed the issue of whether the requirement 
in the Dodd-Frank Act that a transaction be ``intended to be 
physically settled'' in order to qualify for the forward exclusion 
from the swap definition with respect to nonfinancial commodities 
reflects a change in the standard for determining whether a 
transaction is a forward contract. Because a forward contract is a 
commercial merchandising transaction, intent to deliver historically 
has been an element of the CFTC's analysis of whether a particular 
contract is a forward contract. In assessing the parties' 
expectations or intent regarding delivery, the CFTC consistently has 
applied a ``facts and circumstances'' test. Therefore, the CFTC 
reads the ``intended to be physically settled'' language in the swap 
definition with respect to nonfinancial commodities to reflect a 
directive that intent to deliver a physical commodity be a part of 
the analysis of whether a given contract is a forward contract or a 
swap, just as it is a part of the CFTC's analysis of whether a given 
contract is a forward contract or a futures contract. Proposed Rule 
on ``Further Definition of `Swap,' `Security-Based Swap,' and 
`Security-Based Swap Agreement'; Mixed Swaps; Security-Based Swap 
Agreement Recordkeeping, 76 FR 29818, 29828 (May 23, 2011) 
(``Proposed Products Release'').
    This interpretation was ratified in the final rule, ``Further 
Definition of `Swap,' `Security-Based Swap,' and `Security-Based 
Swap Agreement'; Mixed Swaps; Security-Based Swap Agreement 
Recordkeeping, 77 FR 48208, 48227-48228 (August 13, 2012) 
(``Products Release'').

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[[Page 28244]]

    An option, in contrast, is only the option to undertake such a 
``sale'', not the sale itself. The sale occurs only when the option 
is exercised. The option to buy or sell a commodity at some later 
point simply is not the same thing as the sale of that commodity 
itself. The Commission's Office of the General Counsel memorialized 
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this interpretation in 1985:

    [T]he [forward] contract must be a binding agreement on both 
parties to the contract: One must agree to make delivery and the 
other to take delivery of the commodity. Second, because forward 
contracts are commercial, merchandizing transactions which result in 
delivery, the courts and the Commission have looked for evidence of 
the transactions' use in commerce. Thus, the courts and the 
Commission have examined whether the parties to the contracts are 
commercial entities that have the capacity to make or take delivery 
and whether delivery, in fact, routinely occurs under such contracts
* * * * *
    Thus, an option is a contract in which only the grantor is 
obligated to perform. As a result, the option purchaser has a 
limited risk from adverse price movements. This characteristic 
distinguishes an option from a forward contract in which both 
parties must routinely perform and face the full risk of loss from 
adverse price changes since one party must make and the other take 
delivery of the commodity. In contrast, in an option, only the 
grantor of a call (put) is required to sell (buy) a given quantity 
of a commodity (or a futures contract on that commodity) on or by a 
specified date in the future if the option is exercised. 
``Characteristics Distinguishing Cash and Forward Contracts and 
`Trade Options' '', 50 FR 39656-02 (September 30, 1985)
    The Commission ratified this interpretation in 1990 in its 
``Statutory Interpretation Concerning Forward Transactions'', 55 FR 
39188-03 (September 25, 1990) (``Brent Interpretation'') and again 
in 2012 its final rule, ``Further Definition of `Swap,' `Security-
Based Swap,' and `Security-Based Swap Agreement'; Mixed Swaps; 
Security-Based Swap Agreement Recordkeeping, 77 FR 48208, 48227-
48235 (August 13, 2012) (``Products Release''). In doing so, the 
Commission explicitly rejected the argument that physically-
delivered commodity options could fall within the forward contract 
exclusion.\2\
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    \2\ See also, Products Release at 4236-37.
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    The interpretation being promulgated today does not change this, 
and therein lays my concern regarding this interpretation's limits.
    I think much of the confusion regarding the seven-part test has 
been based upon a failure to recognize the difference between 
forward and option contracts under the Commodity Exchange Act. The 
fact that a forward contract element and a commodity option are 
packaged together does not change the regulatory treatment of the 
different components. Hybrid or packaged instruments are common 
throughout the industry. There are hybrid or packaged instruments 
which may have characteristics of futures contracts and securities, 
swaps and security-based swaps, futures and forward transactions, 
and even forward contracts and commodity options. Each portion of 
the contract might be subject to different regulatory treatment. A 
security does not become a future, nor does a future become a 
security simply by virtue of being packaged in the same instrument.
    Relevant to the instruments we are discussing today, forward 
contracts with embedded volumetric optionality, it seems that most 
of them, as described in the comments, have at least two separate, 
identifiable contractual obligations, each of which must be 
considered on their own merits. There is a forward contract element 
which binds the parties to make and take delivery of a set amount of 
a commodity. In addition, there is an embedded volumetric 
optionality element that binds the forward contract offeror to make 
or take delivery of an additional amount of the commodity if the 
embedded volumetric optionality is exercised by the forward contract 
offeree. The latter contractual obligation looks like a classic 
option.
    The difficulty this interpretation faces in providing the relief 
industry seeks is this: Even though the embedded optionality has the 
form of an option, can it somehow fit within the forward exclusion? 
The answer this interpretation gives is, essentially, yes, it can, 
if it can be demonstrated that, despite the embedded optionality 
having the form of an option, it is utilized, in practice, as a 
forward contract. While the seven-prong test and the interpretive 
guidance around it do not provide an exact roadmap for determining 
when embedded volumetric optionality included in a forward contract 
may or may not fall into the option definition, or when embedded 
volumetric optionality may undermine a forward contract, I think it 
does provide a good sense of the factors that parties must consider 
in making those determinations for themselves.
    Such a test, however, is necessarily a facts and circumstances 
test with no bright lines. Ensuring compliance with this 
interpretation poses a challenge, and, therefore, that is an area 
where I would like to see greater legal certainty for these 
contracts.
    In closing, I support this final interpretation, but I think 
industry would benefit from broader relief that provides greater 
legal certainty. I look forward to continuing to work with my fellow 
Commissioners and staff to make sure that commercial entities have 
access to the tools they need to manage the commercial risks of 
their operations.

[FR Doc. 2015-11946 Filed 5-15-15; 8:45 am]
 BILLING CODE 8011-01-p 6351-01-P


