Participants in the energy industry have more exposure to energy commodity price volatility and risk than many other commercial sectors. During the course of many decades, the industry has employed a number of contracts, financial instruments and other techniques to manage or “hedge” these risks. Among these techniques are the use of financial derivatives contracts, forward contracts and pooling of risk among multiple project participants.
The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law on July 21, 2010, in response to the perceived regulatory failures in the U.S. financial system resulting in the financial crisis of 2007-2008. Title VII of Dodd-Frank requires an overhaul of federal regulation of many financial instruments and contracts that energy companies employ to hedge commercial risk. Under Title VII, certain classes of persons that transact in financial derivatives contracts, or “swaps,” will be subject to an array of new regulations, including capital, margin and reporting requirements; mandatory clearing and trade execution requirements; and increased scrutiny.
The cost of compliance with these new regulations is expected to be high, and significant uncertainty remains regarding their application. Dodd-Frank was, however, intended to be directed toward “market-makers” that posed risk to the financial sector as a whole, and not energy companies seeking to hedge commercial risk, even though Dodd-Frank has not adequately made this distinction. Although the Commodity Futures Trading Commission has addressed some of the uncertainties for the energy industry caused by Dodd-Frank, some problems and uncertainties remain.
After significant delay, this year the CFTC finally promulgated definitions for the key concepts of swap, swap dealer and major swap participant.
• Swaps. Dodd-Frank defines “swaps” to include instruments or contracts that “provid[e] for any purchase, sale, payment or delivery…that is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence.” Dodd Frank § 721(a)47(A)(ii). The CFTC has issued several clarifications to this broad statutory definition of swaps. CFTC and SEC final Rule Release, 55 Fed. Reg. 39188 (September 25, 1990) (there is also a category of “security-based swaps” regulated by the U.S. Securities and Exchange Commission that is beyond the scope of this article).
Critically, forward contracts are excluded from the definition of swaps, and therefore from the bulk of the CFTC regulatory scheme governing trading in financial derivatives, or “futures.” In contrast to futures (which are derivatives settled financially rather than physically), a forward contract is a contract for physical delivery of, e.g., an energy commodity, for which actual delivery is deferred to a future time after payment. Other industry contracts that may qualify for the forward-contract exemption include contracts with embedded volumetric optionality, contracts for environmental commodities such as emissions allowances, physical exchange transactions and fuel-delivery agreements.
• Swap dealer. A “swap dealer” is any person or entity that holds itself out as a dealer in swaps; makes a market in swaps; regularly enters into swaps with counterparties in the ordinary course of business for its own account; or engages in activity causing itself to be commonly known as a dealer or market maker in swaps. The new rules describe “making a market in swaps” as being routinely ready to enter into swaps at the request or demand of a counterparty, and entering into swaps is part of one’s “regular business.” Entering into swaps is considered part of one’s regular business if it satisfies the business or risk-management needs of the counterparty, if the entity maintains a separate profit-and-loss statement for swap activities, and if it allocates staff or resources to dealer-type activities. After some uncertainty, the CFTC has made it more clear that a typical end-user is not a swap dealer.
• Major swap participant. A “major swap participant” is any person or entity that satisfies any of the following criteria: The person maintains a “substantial position” in any of several major swap categories; the person has outstanding swaps that create “substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets”; and the person is a “financial entity” that is “highly leveraged relative to the amount of capital such entity holds and that is not subject to capital requirements established by an appropriate federal banking agency,” and that maintains a “substantial position” in any of several major swap categories.
A person may also be exempt if he or she engages only in a de minimis quantity of swap dealing (defined as $3 billion or less over a 12-month period, phased in over a period in which the de minimis threshold would be $8 billion per year).
Dodd-Frank also expands the definition of a commodity pool to include any form of enterprise operated for the purpose of trading in commodity interests, including swaps. Similarly, the term “commodity pool operator” (CPO) is expanded to include any person engaged in a business that is of the nature of an investment trust and, in that connection, solicits funds for the purpose of trading in any commodity for future delivery or commodity option.
The CFTC has taken an expansive view of the term “trading” in commodity interests, and thus a pooled investment vehicle that enters into swaps (but that does not actively trade them) might fit within the definition of a commodity pool. The question is: If trading in swaps is a purpose (even if not the sole purpose) of the investment vehicle, will the CFTC take the position that the vehicle is a commodity pool, no matter how limited such trading is in scope, and regardless of whether undertaken for hedging or speculative purposes? The answer remains unclear. The CFTC has, however, provided some guidance involving securitization vehicles, which may help determine whether other investment vehicles would be categorized as a commodity pool.
On October 11, the CFTC issued a response to a request for exclusion from commodity-pool regulations for securitization vehicles. At issue was whether operators of certain funds that issue asset-backed securities must register as CPOs. The CFTC response touched on a number of factors that may be relevant to whether a fund is a commodity pool, including the securitization vehicle solicits and combines funds to invest in commodity futures contracts; the securitization vehicle uses common funds on behalf of the entire account; participants share in profits or losses; and the securitization vehicle operates in its own name.
If the CFTC interprets Dodd-Frank consistent with the above interpretation, then an energy fund or energy investment vehicle may not be a CPO if it fails to meet the factors above. In one instance, an informal conversation with CFTC staff indicated that the CFTC was not likely to consider the energy company involved to be a CPO merely because it was engaged in ancillary hedging of its physical production against price volatility. However, this conversation is not binding on the CFTC and in any case is limited to the particular facts involved.
To that end, a company should avoid marketing itself as a pool, holding itself out for the purpose of being a vehicle for investing in commodities or futures markets or promising a return to its investors based on its hedging, and should attempt to make its hedging activities separate and distinct from its primary business purpose. Most of the burdens of Dodd-Frank compliance will fall on persons who will be classified as “swap dealers” or “major swap participants,” and do not qualify for the end-user exception to clearing.
However, Dodd-Frank still imposes certain burdens on end-users. For example, as of January 1, 2013, a company must obtain new identification information from the CFTC and pay a registration fee to enter into new trades. Also, swap counterparties may require disclosure of certain information and/or the institution of new written policies before entering into swaps. Although commercially astute swap dealers will try to minimize these burdens, in many cases the Dodd-Frank regulations will require such swap dealers to make demands that their customers will, at least initially, find confusing or frustrating.
In sum, most energy companies stand a reasonably good chance of avoiding the brunt of the Dodd-Frank regulations. Companies should examine their contracting procedures for possible areas where they or their trading activities may not fit within one of the exclusions, and attempt to address these areas prior to January 1, 2013, when many of the compliance obligations under Dodd-Frank come into effect.
Lucas A. LaVoy is an associate and Rebecca R. Seidl is an attorney in the oil and gas practice group of Thompson & Knight’s Houston office.