S k a d d e n, A r p s, S l a t e, M e a g h e r & F l o m L L P & A f f i l i a t e s If you have any questions regarding the matters discussed in this memorandum, please contact the following attorneys or call your regular contact. Houston Ann A. Hawkins 713.655.5104 ann.hawkins@skadden.com New York Paula S. Greenman 212.735.2789 paula.greenman@skadden.com John W. Osborn 212.735.3270 john.osborn@skadden.com Washington, D.C. Philip McBride Johnson 202.371.7340 philipmcbride.johnson@skadden.com * * * This memorandum is provided by, Arps, Slate, Meagher & Flom LLP and its affiliates for educational and informational purposes only and is not intended and should not be construed as legal advice. This memorandum is considered advertising under applicable state laws. July 22, 2010 Energy Derivatives Under the Dodd-Frank Act On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act or the Dodd-Frank Act). The derivatives legislation set forth in Title VII of the Act (titled "Wall Street Transparency and Accountability") repeals prior regulatory exemptions for over-the-counter (OTC) derivatives, including energy derivatives, and imposes a regulatory framework upon the OTC derivatives market. 1 In addition, Title VII of the Act provides substantial authority to the Commodity Futures Trading Commission (CFTC) with respect to position limits for certain swaps and may change the standards for determining manipulation. While the majority of the reforms contained in the Act are focused on the financial industry, the legislation could affect energy companies, including by increasing their hedging costs. This memorandum is intended to provide a high-level overview of those derivative matters in the Act that may be of interest to energy companies. 2 While the Act leaves many key concepts and processes to be delineated by regulation, it is clear that the Act will affect to some degree the conduct of derivatives activities for all market participants. The impact will vary greatly depending upon the type of business enterprise, the types and amounts of swap transactions in which it engages, and the purpose for which it engages in them. For example, a company that currently uses OTC contracts to trade fuel, power, emissions or other commodities may be required, if no exemption applies, to clear such swaps with a clearinghouse and trade them through an exchange. Due to the margining requirements associated with such clearing and trading, the new mandatory clearing and exchange trading requirements under Title VII of the Act may increase a company's cost of hedging and affect its liquidity. Companies that qualify as end users and use these instruments to hedge are expected to be the relatively least affected by the new swaps regime. However, as discussed below, many types of companies will not qualify for that exemption. In addition, while there is a forward contract exception to the new requirements for "swaps," overlapping jurisdiction issues between the CFTC and the Federal Energy Regulatory Commission (FERC) remain, and, therefore, companies may find themselves reporting to both the CFTC and the FERC on the same transaction. Four Times Square, New York, N.Y. 10036 Telephone: 212.735.3000 WWW.SKADDEN.COM 1 For a broader and more in-depth discussion of Title VII of the Act, please see the section titled "Derivatives" in our memorandum "The Dodd-Frank Act: Commentary and Insights," and the more extended analysis in the article titled "Regulation of Over-the-Counter Derivatives Under the Dodd-Frank Wall Street Reform and Consumer Protection Act" included in the memorandum. 2 This summary does not discuss the regulation of security-based swaps, which are within the jurisdiction of the Securities and Exchange Commission.
2 Effective Date With limited exceptions, the provisions of Title VII of the Act become effective on the later of 360 days following enactment or, to the extent a provision of Title VII of the Act requires a rulemaking, not less than 60 days after publication of the final rule or regulation by the relevant regulators, primarily being the CFTC for energy transactions (such date, the General Effective Date). These rulemakings will address many key points under the legislation that have been delegated to the relevant regulators to implement. Over-the-Counter Energy Derivatives Under the pre-act provisions of the Commodity Exchange Act (CEA), the CFTC has limited jurisdiction to oversee OTC energy derivatives. Pursuant to the Commodity Futures Modernization Act of 2000, Congress, as a matter of statute, provided that contracts, agreements and transactions in certain "exempt commodities," including energy commodities, entered into between eligible contract participants outside of a trading facility or between eligible commercial entities on an electronic trading facility generally would not be subject to CFTC regulation. 3 These contracts, agreements and transactions would be subject, however, to anti-fraud and anti-manipulation provisions of the CEA and additional provisions relating to significant price discovery contracts. Title VII of the Act will repeal the exemption from regulation under Section 2(h) of the CEA for "exempt commodity" OTC contracts. 4 While a short-term extension (of up to one year) of the rules under Section 2(h) of the CEA with respect to "exempt commodities" (as in effect the day before the enactment of the Act) may be available, a person must submit a petition to the CFTC for such extension not later than 60 days after the date of enactment of the Act. 5 OTC energy swaps and options that currently enjoy a limited regulatory regime may be subject to clearing requirements and will be subject to other requirements intended to increase transparency of the OTC derivatives market and to reduce the potential for counterparty and systemic risk. Mandatory Clearing and Exchange Trading Requirements 6 The Act requires 7 that (subject to the end user exception described below) any swap must be (i) cleared through a designated clearing organization 8 and (ii) traded on a designated contract market or a swap execution facility if: in the case of clearing, the swap is of a type that the CFTC determines must be cleared and is accepted for clearing by a derivatives clearing organization; and 3 7 U.S.C. 2(h). 4 Act 723(a)(1). 5 Act 723(c). The extension is not automatic; the CFTC must first grant it based on the petition, a process that the Act requires the CFTC to complete "promptly." 6 Act 723 (to be codified at 7 U.S.C. 2). 7 The clearing requirement does not include an explicit transition period; therefore the requirements start on the General Effective Date (as defined above), subject to products being approved for clearing. 8 A derivatives clearing organization is a category of activity for which the entity must be registered with the CFTC and must adhere to strict CFTC operating standards.
3 in the case of trading, a designated contract market or a swap execution facility makes the swap available to trade. 9 "Swap" is broadly defined to include most types of OTC derivatives, including energy swaps, emission swaps and commodity swaps, subject to a carve-out for "security-based swaps" and certain other specified exemptions. 10 The definition of "swap" excludes, among other categories, "any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled." Based on legislative history, this exclusion is intended to be consistent with the pre-act forward contracts exclusion in the CEA and the CFTC's policy on forward contracts. Accordingly, the exclusion also would apply to transactions where the parties mutually agree after entering into forward contracts to settle their physical delivery obligations with a payment based on a price difference through a "book-out." Swaps entered into before enactment of the Dodd-Frank Act, or following enactment but prior to clearing becoming mandatory, are grandfathered from the clearing requirement 11 but will be subject to reporting requirements. There is some ambiguity, which has provoked concern in the business community, as to whether margin requirements may be imposed retroactively on existing swaps. However, while not yet certain, it is widely anticipated that a technical corrections bill or the rulemaking process will clarify that margin will not be imposed retroactively on most swap counterparties (at least those that are not swap dealers or major swap participants). End User Exemption An exemption from the clearing and exchange trading requirements will be available to counterparties that qualify as end users. The exemption is available to a counterparty that (i) is not a financial entity, (ii) is hedging its own commercial risk, 12 and (iii) notifies the CFTC, in a manner to be set forth by regulation, how it generally meets its financial obligations associated with entering into uncleared swaps. A public company that wishes to rely on the end user exemption also will be required to obtain the approval of its board of directors or governing body. 13 However, as discussed below, the end user determination is not entirely straightforward. In addition, it is expected that qualified end users will not be subject to mandatory margin requirements imposed by regulation on their uncleared swaps, as opposed to whatever margin requirements may be negotiated with their counterparties. However, certain key wording that was in the Senate 9 A swap that is of a type required to be cleared and is accepted by a clearing house must be cleared even if no exchange makes the swap available to trade. 10 Act 721(a) (to be codified at 7 U.S.C. 1a). 11 Act 723 (to be codified at 7 U.S.C. 2). 12 The CFTC has the authority, but is not required, to delineate by rulemaking the term "commercial risk." 13 Act 723 (to be codified at 7 U.S.C. 2). Please note that the CFTC may push back if it does not accept as reasonable the company's explanation of how it meets those financial obligations. Until clarified by regulation, it is not known how cumbersome the regulatory notice and board approval requirements will be, including whether the necessary notifications and approvals may be made on a blanket basis, perhaps subject to periodic renewals, or whether they will be required to be obtained for each uncleared transaction.
4 version of the legislation was omitted from the Act as it emerged from the House-Senate Conference. There is helpful legislative history expressly addressing this issue, but the outcome will be uncertain until definitively addressed in a technical corrections bill or by rulemaking. Even assuming availability of the end user exemption, and that qualified end user swaps will not be subject to mandatory margin requirements, it appears likely that the costs of hedging generally will increase, including due to the capital charges to be imposed upon swap dealers in connection with uncleared swap transactions. In addition, the limitations on banks' derivatives activities, discussed below, may reduce competition in the OTC derivatives market. Potential Registration and Regulatory Requirements Defined terms such as "financial entity," "major swap participant" and "swap dealer" could apply to numerous companies outside of the financial services sector; among other things, companies whose derivatives activities cause them to be categorized as swap dealers or major swap participants will be considered "financial entities" even if their business is otherwise non-financial in nature. Accordingly, an energy company that engages in trading activities, for example, should evaluate whether its activities could constitute acting as a "swap dealer," in which case it would not be eligible for the end user exemption. Similarly, energy companies that maintain very large derivatives positions, other than to hedge or mitigate their commercial risk, could potentially be subject to regulation as major swap participants, which also would preclude eligibility for the end user exemption. Given that key components of the term "major swap participant" remain to be specified by regulation, for some market participants the requirements applicable to their derivative activities, which may include registration and other substantial compliance requirements, will be unclear until final regulations are issued. In addition, given the broad definition of "swap dealer," which may not be clarified by rulemaking, 14 some questions may remain even after final regulations are available. Practical Considerations of Required Clearing Entering into cleared transactions will require swap counterparties to post initial margin and to post (or receive returns of) variation margin at least daily, and, potentially on additional occasions, intraday. For swap users that have been sufficiently creditworthy not to post margin in the OTC market, or to have posted margin in lesser amounts than may be required by clearinghouses once the clearing requirements become effective, the change in margin requirements could reduce available liquidity and effectively increase the cost of hedging or otherwise using derivatives. In addition to the increased out of pocket and opportunity costs of meeting increased margin requirements, many companies may not have a treasury function that is equipped to readily handle daily or intraday posting requirements, and may need to turn to banks to provide treasury services and lines of credit to cover margin calls. Reporting Requirements The Dodd-Frank Act generally requires that swap transactions and pricing data on cleared and uncleared swaps be reported publicly (using "real-time public reporting"). 15 Swaps entered into 14 Presumably, the definition of "swap dealer" will be clarified by rulemaking to provide the criteria for the de minimus activity exception contemplated by the definition and to the extent deemed necessary for anti-evasion purposes. 15 Act 727 (to be codified at 7 U.S.C. 2(a)).
5 prior to the enactment (or post-enactment, but prior to the effective date of the clearing requirement) will be subject to the reporting and recordkeeping requirements for uncleared swaps. 16 Restrictions on Banks The Dodd-Frank Act includes a provision that, following a transition period, will effectively limit the derivative activities of banks or other entities with access to Federal Reserve credit or FDIC assistance. The permitted category of swap activities appears to include interest rate swaps, foreign exchange swaps, gold and silver swaps and cleared credit default swaps referencing investment grade securities, and to exclude other derivatives that are not part of the institution's own hedging activities, including energy derivatives. The nonpermitted swap activities may, however, be conducted in a separately capitalized, non-bank affiliate. The derivatives activities of insured depository institutions and their affiliates are further constrained by the "Volcker Rule," which limits the ability of such entities to engage in proprietary trading (i.e., engaging as a principal for the trading account used for its own account and risk) of any security, derivative, contract of sale of a commodity for future delivery and other contracts as may be determined by the appropriate regulatory agencies, subject to certain exceptions. These restrictions on banks' derivatives activities could materially impact the costs and terms of derivatives contracts in the future as well as liquidity for hedges and could potentially reduce competition for swap providers. Position Limits 17 The Dodd-Frank Act significantly expands the CFTC's authority to impose broader aggregate position limits. The relevant provision is effective upon the enactment date but remains to be implemented by CFTC order or rulemaking. In general, these restrictions can be imposed upon futures contracts; options; newly-regulated swaps that are "economically equivalent" to the foregoing; all exchange-listed swaps; and swaps that perform or affect a "significant price discovery function" with respect to a registered entity such as a board of trade or a registered derivatives clearing organization, and it is expected that such position limits would apply in the energy space. In the past, the responsibility for setting position limits had been shared with the exchanges. The CFTC now has an obligation to fix aggregate position limits on futures, options on futures or commodities traded on a regulated exchange, as well as swaps that are "economically equivalent" to the foregoing, in each case with respect to the same underlying physical commodity (including energy commodities and excluding "excluded commodities" such as interest rates, exchange rates and currency). This aggregate position limit excludes bona fide hedges and includes positions held on a foreign board of trade that settle off a U.S. market's price if direct electronic access to the matching engine is provided by the foreign board of trade. The limits with respect to such physical commodities are required to be established within 180 days after the date of enactment of the Act. Any position limit established under the Act does not apply to positions acquired in good faith prior 16 Act 729 (to be codified at 7 U.S.C. 6o-1) and 723 (to be codified at 7 U.S.C. 2). Title VII of the Act has overlapping and inconsistent provisions addressing the reporting of this information. Under one set of provisions, the deadline for such transitional reporting is no later than 30 days after the effective date of the "interim final rule" (which in turn is required to be finalized within 90 days following enactment) or such other period as the CFTC determines to be appropriate. See Act 729 (to be codified at 7 U.S.C. 6o-1). Another set of provisions specifies a later date, following the General Effective Date, for both pre-enactment and post-enactment swaps. See Act 723 (to be codified at 7 U.S.C. 2). These disparities presumably will be addressed by rulemaking. 17 Act 737 (to be codified at 7 U.S.C. 6a(a)).
6 to the effective date of the rule or regulation establishing such limit; provided that such preeffective date positions will be attributable to the trader if the trader increases his position after the effective date. 18 Earlier this year the CFTC proposed to set position limits for listed energy derivatives, but three commissioners expressed serious reservations. 19 The Act will moot these objections. Anti-Manipulation Authority 20 The Act broadens the prohibitions against manipulation by prohibiting a person, directly or indirectly, from using or attempting to use manipulative or deceptive devices in connection with any swap, contract or sale of any commodity in interstate commerce, or for future delivery on a registered exchange in contravention of rules to be promulgated by the CFTC not later than one year after enactment of the Act. Until now, the courts construing CFTC law have held that manipulation requires proof that the person deliberately intended to affect prices. The new provision may allow a court to determine from all of the evidence that the person knew or should have known that his actions would affect prices. CFTC and FERC Jurisdiction 21 Pursuant to the Act, the CFTC and FERC have up to 180 days after the date of enactment of the Act to negotiate a memorandum of understanding to establish procedures for resolving conflicts concerning overlapping jurisdiction 22 between the two agencies and avoiding conflicting or duplicative regulation. As an example of potential overlapping authority, without limiting the CFTC's authority over such matter, the Act specifically provides that it does not affect any statutory authority of the FERC or a State with respect to an agreement, contract or transaction that is entered into pursuant to a tariff or rate schedule approved by the FERC or a State regulatory agency so long as such agreement, contract or transaction is (i) not traded or cleared on a registered entity or trading facility, or (ii) if it is traded or cleared on a registered entity or trading facility, such registered entity or trading facility is owned or operated by a regional transmission organization or independent system operator. Financial transmission rights were a particular issue in the negotiation of the legislation, and it appears that they may remain an issue until resolved by the CFTC and the FERC. The CFTC and the FERC will submit such memorandum to the appropriate committees of Congress, and such memorandum may lead to additional rulemaking affecting energy products. 18 Act 739 (to be codified at 7 U.S.C. 25(a)). 19 75 Fed. Reg. 4144 (Jan. 26, 2010), reprinted at 2 Comm. Fut. L. Rep. (CCH) 31,511. 20 Act 753 (to be codified at 7 U.S.C. 9, 15). 21 Act 720 and 722(e) (to be codified at 7 U.S.C. 2(a)(1)). 22 Until now, the courts have ruled uniformly that under the plain language of the Commodity Exchange Act the CFTC has "exclusive jurisdiction" to regulate commodities activity except for the conveyance of the real physical commodity between a seller and a buyer. It is not clear whether the new Act is meant to alter that relationship.
7 Energy and Environmental Markets Advisory Committee 23 The Act establishes an Energy and Environmental Markets Advisory Committee with no specific charter. The committee will conduct public meetings and submit reports and recommendations to the CFTC. In particular, the committee will serve as a place for exchanges, end users and regulators to discuss matters of concern regarding energy and environmental markets and their regulation by the CFTC. Additional rulemakings relating to energy and environmental markets may follow recommendations from this committee. Also of note, the Act establishes a new interagency working group to conduct a study on the oversight of existing and prospective carbon markets to ensure a transparent carbon market, including oversight of spot and derivative markets. 24 Additional rules relating to carbon trading may follow recommendations from this committee. 23 Act 751 (to be codified at 7 U.S.C. 2(a)). 24 Act 750.