By: Nathan E. Endrud
With the publication today of a final rule defining the term "swap" under the Dodd-Frank Act, the Commodity Futures Trading Commission (CFTC) started the countdown to numerous compliance obligations that will affect energy companies trading swaps. Understanding which compliance obligations will impact your company and what the new compliance rules will require will be important for business planning in the future.
Do You Engage in "Swaps"?
The term "swap" broadly includes any contract that provides for an exchange of payments based on the value of commodities or other items and that transfers the financial risk associated with future changes in such values without also conveying an ownership interest in the underlying asset. "Swaps" include options, commodity swaps, energy swaps, basis swaps, emission swaps and weather swaps. An important exception excludes "forward contracts" in physical commodities, so long as such contracts are intended to be physically settled at the time of execution. Certain forward contracts with "embedded volumetric optionality" (as exists in many power and natural gas requirements contracts) are exempt from swap regulations so long as they meet a 7-part test. However, pure options, even if physically settled, will be regulated as "swaps." Importantly, the CFTC indicated in the swap definition rulemaking that some power tolling agreements and even firm pipeline capacity agreements may be viewed as "options" and thus "swaps." It has yet to rule on a requested exemption for numerous FERC-regulated products, including Financial Transmission Rights (FTRs).
Are You a "Swap Dealer"?
For companies currently engaging in swap transactions, the most important threshold question is whether or not they are "swap dealers," which must register with the CFTC through the National Futures Association and comply with substantially more burdensome requirements. Unfortunately, there is no bright-line test for what constitutes swap dealing (which, among other things, includes engaging in swaps to accommodate the needs of others as opposed to one's own particular trading purposes). However, a bright-line exception does exist in the form of "de minimis" thresholds of $8 billion (transitioning to $3 billion in approximately 3 to 5 years) in aggregate gross notional amount of swaps (across affiliates) in any 12-month period or $25 million for dealing activities with respect to "special entity" counterparties (governmental bodies, pension plans, endowments). Companies engaging in swaps that believe they are not swap dealers should carefully document their analysis to that effect and seek the advice of counsel so that they can respond to potential inquiries by counterparties or the CFTC.
Can You Still Trade Swaps "Over the Counter"?
As a general rule, all swaps determined by the CFTC as "required to be cleared" must be traded on an exchange and centrally cleared. Non-financial entities, including commercial energy companies that are not swap dealers, may still engage in off-exchange, uncleared swaps so long as they are using such swaps to "hedge or mitigate commercial risk" and provide certain information to a swap data repository (SDR) or the CFTC. Importantly, companies that are regulated by the SEC must obtain board approval of the decision to trade in uncleared swaps and review their swap policy at least annually.
Reporting and Recordkeeping Requirements
Companies engaging in swaps should have already been keeping certain records for, and preparing to report, any swaps that were open as of July 21, 2010. According to the CFTC, all companies engaging in swaps must keep "full, complete, and systematic records, together with all pertinent data and memoranda" until 5 years after termination of each swap. All swaps must be reported to an SDR. The responsibility for reporting falls first on exchanges and clearing organizations, if used; then on swap dealers; then "major swap participants" (participants with at least $1 billion uncollateralized exposure in swaps); and, lastly, on one of the end-user counterparties.
The CFTC also has issued position limits on four major energy contracts traded on NYMEX and all swaps linked to them: (1) Henry Hub Natural Gas (initially, 1,000 contracts in the spot month), (2) Light Sweet Crude, (3) NY Harbor Heating Oil and (4) NY Harbor Gasoline Blendstock. In addition, the CFTC was given new authority to prohibit intentional or reckless manipulative or misleading activities and the following "disruptive trading practices": (1) violating bids and offers; (2) disregarding orderly execution during close (e.g., "slamming the close"); and (3) "spoofing" (bidding or offering with intent to cancel before execution).
Important Compliance Dates
Based on publication of the final rule defining the term "swap" in the Federal Register today, August 13, 2012, the countdown to numerous Dodd-Frank compliance requirements has begun, including the following important compliance dates:
October 12, 2012
- Swap Dealers (SDs) and Major Swap Participant (MSPs)—Registration, Internal Business Conduct Standards, Reporting and Recordkeeping Requirements for Interest Rate and Credit Swaps
- Position Limits (Spot Month)
January 10, 2013
- SDs and MSPs – Reporting and Recordkeeping Requirements for All Swaps
April 10, 2013
- End Users – Reporting and Recordkeeping Requirements for All Swaps