During the Commodity Futures Trading Commission ("CFTC") hearing on the final rule on the 'further definition of swap', many topics were discussed. The volumetric options ability to be included in the forwards exclusion was considered a good thing as were several other items. However, there were several little "Easter eggs" -- as kids call the items "hidden" in video games -- that the CTC appears to have forgotten to mention. All of them may have significant impacts on power, natural gas and other commodity companies.

These are, in order:

1. The treatment of Parental Corporate Guarantees;

2. The treatment of "Certain Physical Commercial Agreements, Contracts or Transactions";

3. The Treatment of EMAs ("Energy Management Agreements").

The first item is found page 67 of the pdf version of the final rule found on the CFTC website here - http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister071012c.pdf - in section B. 1. (g) Guarantees. The CFTC states that "The CFTC finds that a guarantee of a swap (that is not a security-based swap or mixed swap) is a term of that swap that affects the price or pricing attributes of that swap." It goes on to say "Therefore, the CFTC is interpreting the term "swap" (that is not a security-based swap or mixed swap) to include a guarantee of such swap, to the extent that a counter-party to a swap position would have recourse to the guarantor in connection with the position." This can be read to mean that the parent of an unregulated utility affiliate that provides a guarantee has become party to that swap. All PCGs could, therefore, implicate the entire organization in the swap activity.

More concerning is the comment in footnote 188 on that starts on page 69 and continues to page 70 where the following sentences are found; "As a result of interpreting the term "swap" (that is not a security-based swap or mixed swap) to include a guarantee of such swap, to the extent that a counter-party to a swap position would have recourse to the guarantor in connection with the position, and based on the reasoning set forth above from the Entity Definitions Release in connection with major swap participants, the CFTC will not deem holding companies to be swap dealers as a result of guarantees to certain U.S. entities that are already subject to capital regulation. It may, however, be appropriate to regulate as a swap dealer a parent or other guarantor who guarantees swap positions of persons who are not already subject to capital regulation by the CFTC (i.e., who are not swap dealers, major swap participants or FCMs)." This would imply that providing credit support in a non-competitive pricing structure between a parent and subsidiary could, in some circumstances, be considered swap dealing and -- it would appear -- cover the notional amount of all transactions completed under that parental guarantee. That is not something that the industry appears to have been considering as a potential Dodd Frank risk.

It is PDF Commodity Solutions' understanding that there will be a Notice of Proposed Rule Making clarifying and addressing the practical effect of the discussion of guarantees. It will be important for firms to fully understand the nature and extent of their guarantee relationships in the Dodd Frank context to be able to rapidly interpret the impacts of the CFTC interpretation and to respond accordingly to the CFTC and the internal business impacts.

The second item deals with the definition of contracts common in the logistics of the commodity markets. In Section B. 2. (b) (iii), the CFTC considers an innocuous sounding topic "Certain Physical Commercial Agreements, Contracts or Transaction" starting on page 128. The concern begins very quickly when the CFTC states "The CFTC is providing an interpretation in response to comments regarding certain physical commercial agreements for the supply and consumption of energy that provide flexibility, such as tolls on power plants, transportation agreements on natural gas pipelines, and natural gas storage agreements." This follows directly on the heels of volumetric optionality contracts which could be considered to cover these types of contracts. The CFTC obviously believes these are different.

The CFTC indicates it is setting forth a test for when these types of agreements are not an option. The test states:

"The CFTC will interpret an agreement, contract or transaction not to be an option if the following three elements are satisfied: (1) the subject of the agreement, contract or transaction is usage of a specified facility or part thereof rather than the purchase or sale of the commodity that is to be created, transported, processed or stored using the specified facility; (2) the agreement, contract or transaction grants the buyer the exclusive use of the specified facility or part thereof during its term, and provides for an unconditional obligation on the part of the seller to grant the buyer the exclusive use of the specified facility or part thereof;377 and (3) the payment for the use of the specified facility or part thereof represents a payment for its use rather than the option to use it."

This clearly implies "virtual storage" is an option; it would also imply the resale of interruptable transport from firm capacity that is not being utilized would also default the underlying agreement into a Dodd Frank swap. To make the CFTC's position crystal clear, the last paragraph of this section states "However, in the alternative, if the right to use the specified facility is only obtained via the payment of a demand charge or reservation fee, and the exercise of the right (or use of the specified facility or part thereof) entails the further payment of actual storage fees, usage fees, rents, or other analogous service charges not included in the demand charge or reservation fee, such agreement, contract or transaction is a commodity option subject to the swap definition."

It is PDF Commodity Solution's belief that this interpretation of natural gas storage and transport agreements as well as power plant tolling agreements casts the CFTC regulatory net in a direction the industry did not anticipate and in a manner that will cause much greater impact on many firms than they had previously anticipated. PDF has spoken with members of industry working groups that are seeking an opportunity to speak directly with the CFTC about this ruling but, at this time, this is the final rule on the Dodd Frank swap definition and must be planned for accordingly in implementation efforts.

Finally, the CFTC addresses "Energy Management Agreements" in the very next Section B. 2. (b) (iv) also rather innocuously called "Effect of Interpretation on Certain Agreements, Contracts and Transactions". The CFTC first indicates that tolling agreements, storage, ancillary services and other agreements fall under the interpretive guidance just discussed for Section B. 2. b. (iii) (which implies any capacity or ancillary services with a two part rate is also a swap). As far as EMAs and logically, by extension, any AMA ("Asset Management Agreement") would be impacted, the CFTC indicates that the EMA is not controlling as to the impact. Rather, it is the underlying transactions and services provided under the EMA.

The CFTC says: "EMAs can include services such as: (i) acting as a financial intermediary by substituting one party's credit and liquidity for those of a less credit worthy owner of illiquid energy producing assets (i.e. the other party to the EMA) to facilitate the owner's purchase of fuel and sale of power; (ii) providing market information to assist the owner in developing and refining a risk-management plan for the plant; and (iii) procuring fuel, arranging delivery and storage, selling excess power not needed to serve load for another party. The entity carrying out these activities may receive a portion of the revenue generated from such activities as compensation for its efforts. Because commenters did not provide a working definition of EMAs, the CFTC cannot state categorically that EMAs are or are not swaps. However, if the fuel acquisition, sales of excess generation and any other transactions executed under the auspices of an EMA are not swaps, nothing about the fact that the transactions are executed as a result of or pursuant to an EMA transforms the transactions into swaps." The CFTC is looking to the transactions and services to be performed rather than the EMA structure.

The more troubling aspect for an energy firm is the following language; "For example, if one party hires another party to enter into spot or forward transactions on its behalf, the fact that their relationship is governed by an EMA does not render those transactions swaps. Conversely, were swaps to be executed by one party on behalf of another party as a result of, or pursuant to, an EMA, the parties thereto would need to consider their respective roles thereunder (e.g. principal versus agent) and whether commodity trading advisor, introducing broker, futures commission merchant, or other registration or other elements of the Dodd-Frank Act regime were implicated. At a minimum, the fact that a swap was executed would implicate reporting and record keeping requirements."

This has impacts on both energy company and for its AMA counter-party. Under the CFTC guidance, a concern that the PDF principals have held for over a year is articulated by the CFTC:

Consultants and firms that provide risk management services on behalf of a utility or other asset owner -- either through acting as agent for the procurement or sale of swap transactions (which now include storage and transport contracts) or by providing specific transaction structuring and negotiation services, including acting as intermediary to locate appropriate counter-parties- are possibly subject to significant CFTC registration requirements.

The CTA exposure should be carefully considered -- the CFTC has previously indicated that creating terms of a swap, justification and motivation for timing of a swap or specification of a specific counter-party to deal with on a swap could all constitute acting as a Commodity Trade Advisor ("CTA"). This may reduce the availability of individuals and firms willing to provide these services and raise the costs.

These are the most glaring and immediate concerns for the energy industry -- only through repetitive reading and fitting together this rule with other rules can you start to tease apart the true complexity of this regulatory regime. But it is completely evident that the CFTC has shifted swaps compliance from a cost of doing business to a cost of entry.

Other Posts by: Thomas Lord

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