Legislation Affecting Energy Trading: Recent Developments The House fails to pass Rep. Peterson's Commodity Markets Transparency and Accountability Act of 2008," while the Senate considers Sen. Reid's "Stop Excessive Energy Speculation Act of 2008." SUMMARY On July 30, 2008, the House of Representatives voted but failed to pass a bill introduced by Rep. Collin Peterson (D, MN), while the Senate continues to consider a bill introduced by Majority Leader Sen. Harry Reid (D, NV). Congress is expected to take up both bills again in September. Each of the bills would affect energy and agricultural futures and over-the-counter markets by amending the Commodity Exchange Act to, among other things, potentially impose combined position limits on futures contracts, options and over-the-counter transactions, substantially limit the availability of hedge exemptions, impose additional requirements on foreign boards of trade offering direct access from the United States and impose recordkeeping and reporting requirements on participants in the over-the-counter markets. INTRODUCTION In the past few months, substantial concerns have been raised in Congress regarding a number of issues related to rising prices in the energy and agriculture markets, including the possible role of speculators and commodity index investors in the rise of energy and agriculture prices, off-exchange energy and agriculture trading, and trading on non-u.s. exchanges. These concerns have led to the introduction of more than twenty separate bills addressing these issues. 1 In the last several weeks, the focus has narrowed to a bill introduced by Rep. Peterson entitled Commodity Markets Transparency and Accountability Act of 2008 (the "Peterson Bill"), which was voted upon but not passed by the House, and a bill introduced by Sen. Reid entitled Stop Excessive Energy Speculation Act of 2008 (the "Reid Bill"), which is still pending in the Senate. The Peterson Bill and the Reid Bill are substantially similar in most New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
respects, with some distinctions between them, and would substantially affect the operation and functioning of the agriculture and energy trading markets in the United States. PROPOSED LEGISLATION The principal provisions of the Peterson Bill and the Reid Bill and the material differences between them are the following: Covered Commodities. The Peterson Bill defines energy commodity to mean coal, crude oil, gasoline, diesel fuel, jet fuel, heating oil, propane, electricity, natural gas, and any other substance that is used as a source of energy as the CFTC deems appropriate. The Reid Bill defines energy commodity to mean a petroleum product and natural gas. Both bills also apply, in certain circumstances, to agricultural commodities as that term has been defined in the Commodity Exchange Act. Position Limits. The Peterson Bill requires the Commodity Futures Trading Commission ("CFTC") to set position limits with respect to agricultural and energy commodities traded on designated contract markets, derivative transaction execution facilities, and electronic trading facilities in "significant price discovery contracts" (those that are used as a significant basis of pricing in the over-the-counter ("OTC") and physical markets). Currently, except for agricultural products, this responsibility rests with the exchanges, which have largely moved away from position limits. The position limits must be set at levels designed to, among other things, limit excessive speculation and deter manipulation. The CFTC would be permitted to grant exemptions from the position limits for bona fide hedging transactions. However, both bills narrow the scope of recognized hedging activities. The Peterson Bill limits "bona fide hedging" transactions to those that are directly related to positions or exposures in the physical commodity markets and to OTC derivatives that are entered into with persons engaged in hedging under this definition. The Reid Bill defines legitimate hedge trading as transactions by commercial producers and purchasers of actual physical petroleum and energy commodities for future delivery and the direct counterparties to such trades and requires the CFTC to impose speculative position limits on trading that does not qualify as legitimate hedge trading. The effect of the Peterson Bill and the Reid Bill would be to substantially restrict the availability of hedge exemptions and, specifically, to preclude the granting of hedge exemptions to swap dealers unless a dealer can demonstrate that a particular futures position is hedging a swap with a counterparty that is itself engaged in hedging. This effectively imposes position limits on swaps, narrows the business available to dealers and eliminates many traditional forms of hedging. Speculative Limits and Transparency of Offshore Trading. The Peterson Bill and the Reid Bill require that a foreign board of trade (the FBOT ), providing direct electronic access to its markets to U.S. persons trading in contracts priced against a contract traded on a U.S. exchange, make public daily trading information comparable to that published by the U.S. exchange on which the related contract is -2-
traded. The Peterson Bill also requires these FBOTs to adopt position limits for contracts in agricultural and energy commodities, to have the authority to require market participants to liquidate or reduce positions if necessary to protect against manipulation, and to notify the CFTC regarding position limits and accountability provisions, position reductions, or any other area of interest to the CFTC. The Reid Bill similarly requires the FBOT to adopt position limits or position accountability provisions, but only for contracts in energy commodities, and to notify the CFTC of any change regarding position limits or position accountability provisions. The Peterson Bill does not distinguish between "legitimate" and "nonlegitimate" hedge trading but requires that the FBOT provides information regarding large trader positions and aggregate trader positions, whereas the Reid Bill requires that the FBOT provides information to the CFTC regarding the extent of legitimate and nonlegitimate hedge trading. Over-the-Counter Authority. The Peterson Bill requires the CFTC to conduct a study to determine the need for and appropriateness of position limits on OTC positions for contracts for physical-based commodities to prevent market disruption, excessive speculation or manipulation (although, as noted, the provisions with respect to position limits on exchange-traded contracts effectively would impose limits on OTC positions in any event). The Peterson Bill also instructs the CFTC to determine whether fungible OTC agricultural and energy transactions have the potential to disrupt market liquidity and price discovery functions, cause severe market disturbance, or prevent prices from reflecting supply and demand; and if the CFTC so finds, the Peterson Bill authorizes the CFTC to impose and enforce position limits for speculators trading these fungible OTC agreements. The Reid Bill provides for speculative limits across all markets, including futures, electronic and OTC based on an aggregate futures equivalent exposure. The Reid Bill goes well beyond the Peterson Bill to authorize the CFTC to declare a major market disturbance and, in the event of such disturbance, to require the liquidation of any OTC transaction or to impose limits on OTC positions acquired in good faith before the date of the disturbance. This potential for the CFTC to require the unwinding of bilateral agreements is an unprecedented involvement in the OTC arena. The Peterson Bill requires routine reporting of fungible OTC agricultural and energy transactions, and the Reid Bill similarly imposes recordkeeping requirements with respect to large OTC transactions. Other Provisions. Each of the Peterson Bill and the Reid Bill calls for detailed reporting from index traders and swap dealers in agriculture and energy trading markets, studies of international regulation of energy futures markets, an increase in staffing and resources available to the CFTC, and CFTC review of its prior actions. The Peterson Bill requires the CFTC to disaggregate and publish agriculture and energy market trading information, whereas the Reid Bill requires the CFTC to disaggregate and publish only energy market trading information. Copyright Sullivan & Cromwell LLP 2008 * * * -3-
ENDNOTES 1 See our Memorandum, Proposed Legislation Affecting Energy Trading, dated July 1, 2008. -4-
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