Wednesday, August 21, 2013

CFTC Reporting Obligations Begin for End-Users Engaging in Energy Commodity Swaps


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There are three basic types of transactional reporting requirements imposed by the Commodity Futures Trading Commission (“CFTC”) in regulations implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), including reporting of: (1) historical swaps; (2) new swaps; and (3) commodity trade options. Following the issuance of temporary no-action relief by the CFTC Staff, reporting obligations applicable to end-users are beginning to take effect for energy commodity swaps.

The CFTC defined historical swaps to include both pre-enactment swaps and transition swaps. A “pre-enactment swap” is a swap entered into prior to the date of enactment of the Dodd-Frank Act (i.e., July 21, 2010), the terms of which had not expired as of the date of enactment. A “transition swap” is a swap entered into on or after the enactment of the Dodd-Frank Act and prior to the applicable compliance date for reporting historical swaps data pursuant to Part 46 of CFTC’s regulations. For natural gas and electric utilities which are end-users of swaps and do not fall into the category of either a Swap Dealer (“SD”), Major Swap Participant (“MSP”), or financial entity, the applicable compliance date was April 10, 2013. CFTC Staff granted no-action relief, however, for the reporting of these historical swaps. Pursuant to the latest no-action letter issued by the CFTC Staff, historical energy commodity swaps entered into by such end-users prior to April 10, 2013 must be reported no later than 12:01 a.m. eastern time on October 31, 2013.

With respect to other new energy commodity swaps entered into by end-users on or after April 10, 2013, CFTC Staff granted no action relief until 12:01 a.m. eastern time on August 19, 2013, on the condition that, by 12:01 a.m. eastern time on September 19, 2013, a swap counterparty, which is not an SD, MSP, or financial entity, backload and report to a Swap Data Repository (“SDR”) all transaction data, for the period from April 10, 2013, to August 19, 2013, that such counterparty would have been required to report pursuant to Part 45 in the absence of the no-action relief.

An analysis of an end-user’s contracts and transactions, including the type of counterparty with whom the end-user entered into such contracts and transactions, is necessary to determine whether the end-user is the party which would have been required to report a transaction to an SDR. Often, the reporting obligation will not fall on the end-user because the CFTC established the following reporting hierarchy:
(a) If only one counterparty is an SD, the SD shall be the reporting party.

(b) If neither counterparty is an SD, and only one counterparty is an MSP, the MSP shall be the reporting party.

(c) If both counterparties are non-SD/MSP counterparties, and only one counterparty is a financial entity as defined in section 2(h)(7)(C) of the Commodity Exchange Act (“CEA”), the counterparty that is a financial entity shall be the reporting party.

(d) If both counterparties are SDs, or both counterparties are MSPs, or both counterparties are non-SD/MSP counterparties that are financial entities, or both counterparties are non-SD/MSP counterparties and neither counterparty is a financial entity, the counterparties must reach an agreement on which counterparty will be the reporting party and, for all off-facility swaps (i.e., those not executed on a Swap Execution Facility or Designated Contract Market), the agreement on which counterparty will be the reporting party must actually be included as “a term of the swap transaction.”
Thus, typically an end-user, which is not an SD, MSP or financial entity, will only have to report a swap transaction when its counterparty also is not an SD, MSP or financial entity. There is a significant exception to this reporting hierarchy, however, when a swap transaction is conducted with a foreign entity. Notwithstanding the provisions of paragraphs (a) through (d) above, if both counterparties to a swap are non-SD/MSP counterparties and only one counterparty is a U.S. person, the CFTC’s regulations require that the U.S. person be the reporting party. If your natural gas or electric utility engages in bilateral swap transactions with companies in, for example, Canada or Mexico that are non-MSPs/SDs, it is important to be cognizant of the fact that your utility will bear the burden of reporting a swap.

Moreover, it cannot be assumed that simply because your counterparty engaged in a large number of energy commodity swaps previously that it currently is an MSP or SD which will report the swap transaction. Very few companies are ever expected to register as MSPs and several large companies that trade energy commodity swaps have not yet registered to be SDs because the volume of their swap dealing activity has not yet exceeded thresholds established by the CFTC. Below are links to lists of SDs and MSPs on the CFTC’s website:

SDs: http://www.cftc.gov/LawRegulation/DoddFrankAct/registerswapdealer

MSPs: http://www.cftc.gov/LawRegulation/DoddFrankAct/registermajorswappart

It also is important to be aware that when Congress passed the Dodd-Frank Act, it broadly defined the term “swap” to include options. But, the CFTC issued interpretative guidance, exemptive orders or regulations excluding or exempting certain types of transactions, including some options, from reporting as swaps. For example, the CFTC ruled that when a contract requires delivery of a non-nominal, fixed volume of a non-financial commodity, it may be excluded as a forward contract, notwithstanding the fact that it also contains embedded volumetric options, so long as the contract passes a seven-prong test established by the CFTC. The CFTC cited, as an example, a forward contract requiring the delivery of 10,000 bushels of wheat that includes an option for an additional 5,000 bushels of wheat. The seven prongs that must be met include:
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.
Typically, the seventh prong is most difficult to meet because many options are exercised, or not exercised, in a party’s economic discretion based primarily on the price of the option as compared to other alternatives.

If this seven-prong test is not met, it remains possible that the counterparties and transactions might still qualify for exemptive relief that excuses them from reporting a transaction as a swap if they meet all of the criteria in exemptive orders issued by the CFTC pertaining to: (1) certain transactions exclusively between governmental utilities, electric cooperatives, and tribal utilities; or (2) certain transactions by qualified participants in organized markets operated by Regional Transmission Organizations (“RTOs”) or Independent System Operators (“ISOs”) which are subject to regulation by the Federal Energy Regulatory Commission. An analysis of the counterparties and transactions as compared to the specific criteria in the CFTC’s exemptive orders is necessary to make this determination.

Alternatively, the counterparties and transactions potentially could qualify for a physical commodity trade option exemption. This exemption can be invoked if the following criteria are met:
(1) the offeror is an eligible contract participant or a producer, processor, commercial user, or merchant of the commodity that is the subject of the transaction and is entering into the transaction solely for purposes related to its business as such a producer, processor, commercial user, or merchant of the commodity;

(2) the offeree is a producer, processor, commercial user or merchant of the commodity that is the subject of the transaction and is entering into the transaction solely for purposes related to its business as such a producer, processor, commercial user, or merchant of the commodity; and

(3) the trade option is intended by both parties to be physically settled, so that if exercised, the option will result in the sale of an exempt energy commodity for immediate (spot) or deferred (forward) shipment or delivery.
Originally, the CFTC established two alternative methods for reporting these commodity trade option transactions. One method required such transactions to be reported immediately to an SDR just like all other new swap transactions must be reported pursuant to Part 45 of the CFTC’s regulations. Another less onerous method allowed such transactions to be reported only once a year to the CFTC pursuant to Part 32 of the CFTC’s regulations.

Specifically, the CFTC’s regulations required a commodity trade option transaction to be reported immediately to an SDR when at least one counterparty (whether as offeror or offeree) already has become obligated to comply with the Part 45 reporting requirements as a reporting party for any other type of swap during the twelve month period preceding the date on which the commodity trade option was entered into by the counterparties. In other words, if any one of the two counterparties was already reporting a swap, other than a commodity trade option, the commodity trade option transaction was required to be reported to an SDR too. The CFTC reasoned that if a counterparty is already reporting another swap transaction to an SDR, it should be capable of reporting a commodity trade option transaction too without an undue burden. For the non-SD/MSP, which is designated as the reporting party pursuant to the hierarchy described above, this reporting obligation originally was scheduled to begin on April 10, 2013, but, as explained below, the CFTC Staff granted no action relief.

To the extent the counterparties instead qualified for lighter-handed annual reporting, the CFTC regulations required that both counterparties (not just one of them) submit the annual form providing notice of their respective commodity trade option transactions. This form, entitled “Annual Notice Filing for Counterparties to Unreported Trade Options,” is set forth in Appendix A to Part 32 of the CFTC’s regulations. The first such annual form is due to the CFTC on March 1, 2014.

Shortly before the April 10, 2013 compliance date for reporting of swaps pursuant to Part 45 of the CFTC’s regulations, CFTC Staff issued a no-action letter providing relief to end-users, which are not SDs or MSPs, from the obligation to report a commodity trade option immediately to an SDR. Essentially, the CFTC Staff stated, among other things, that CFTC Staff will not recommend that the Commission commence an enforcement action against a non-SD/MSP reporting party if the non-SD/MSP does not report a commodity trade option to an SDR pursuant to the swap reporting regulations in Part 45, so long as the non-SD/MSP: (1) annually reports the commodity trade option transaction on Form TO pursuant to Part 32; and (2) the non-SD/MSP notifies the CFTC Division of Market Oversight, by email, no later than 30 days after entering into trade options having an aggregate notional value in excess of $1 billion during any calendar year.
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