Corporations and hedging: distinguishing forwards from swaps under the Commodity Exchange Act post-Dodd-Frank.

• Author: Quetsch, Matthew R.

1. INTRODUCTION II. BACKGROUND A. Derivative Instruments 1. Forwards 2. Futures 3. Swaps B. The Dodd-Frank Act C. Product Definitions Rule 1. Nonfinancial Commodity Forwards 2. Embedded Options III. ANALYSIS A. Statutory Framework and the Product Definitions Rule B. Distinguishing Forwards from Futures 1. Defining the Scope of the Forward Exclusion 2. Determining Whether a Contract Falls in the Safe Harbor for Nonfinancial Commodity Forwards 3. Forwards with Embedded Options and Other Provisions C. Effect on Corporations in the Electric Industry IV. RECOMMENDATION A. CFTC B. Courts C. Corporations V. CONCLUSION I. INTRODUCTION

   Many authors have offered explanations for what caused the 2008 financial crisis. (1) Some of these authors point a finger at the careless way in which some companies used derivatives. (2) There are several types of derivatives, but the distinguishing feature of a derivative is that its value is derived from something else's value. (3) This could be anything, including, for example, natural gas, coal, or even weather conditions. (4) The contract price for some amount of electricity to be delivered in two years could depend on the market price for coal in two years. In other words, the contract price for electricity would derive from the future market price of coal.

   Derivatives are used either to hedge or to speculate. (5) Hedging is a way of managing risk by taking offsetting positions in the market. (6) When an electricity-generating corporation buys coal, it might hedge the risk that the price of coal will rise by purchasing an option to sell coal. By taking this offsetting position, it will be able to sell coal at a higher price if it winds up having to buy coal at a higher price. This allows it both to guarantee itself an adequate supply of inputs while at the same time lowering its vulnerability in the event that market prices fluctuate. (7)

   Speculating, on the other hand, is placing a bet that the market price will move one way or the other. (8) Like the generating corporation in the previous paragraph, a speculator who thought the price of coal would go up could purchase an option to sell at that higher price. Unlike the generating corporation, however, which is seeking to smooth things out, the speculator would probably choose to hedge less, if at all. The speculator is not seeking to break even on its investment but to turn a profit. Speculators, in this way, are trying to beat the market. (9) Both hedging and speculating involve a certain amount of risk, which is why some authors blame derivatives markets not only for the most recent financial crisis but for others as well, including the Enron collapse in 2001. (10)

   After the 2008 financial crisis, people demanded that something be done about the use of these somewhat mysterious yet blameworthy financial products. (11) President Barack Obama urged Congress to pass legislation increasing regulation of financial markets. (12) Congress responded with the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), (13) which is the most comprehensive legislation concerning financial markets since the Great Depression. (14)

   This Note examines one small aspect of the complex regulatory scheme that Congress set forth in the Dodd-Frank Act: its amendment to the Commodity Exchange Act (CEA). (15) Congress amended the CEA to include a definition of the term swap, which is one type of derivative. (16) In addition, Congress authorized the Commodity Futures Trading Commission (CFTC) to regulate certain swaps. (17) In its definition of the term swap, Congress expressly excluded certain types of contracts, including forwards. (18) This safe harbor matters for corporations that must comply with the new regulations.

   This Note focuses on the term swap as it applies to corporations that use derivatives for hedging. Particularly, this Note focuses on corporations in the electricity industry because it offers concrete and specific examples. Electricity cannot be stored, so it is common in this industry to hedge because these corporations cannot leave their commodity in a warehouse and wait to sell under more favorable market conditions. (19) Despite this relatively narrow focus, the principles this Note discusses apply beyond the electricity industry.

   Part II describes in more detail some of the common types of derivative instruments, how they are used, and how the Dodd-Frank Act applies. (20) It also introduces the so-called Product Definitions Rule, which excludes from the swap definition certain types of contracts that are of interest to corporations that hedge. (21) Part III analyzes the way in which the CFTC and courts distinguish between forwards--which are beyond the scope of the swap definition--and swaps, which are now subject to regulatory oversight. (22) The fact that forwards are excluded is critical to the analysis.

   This Note recommends three things. (23) First, the CFTC wisely incorporated into the swap context the same principles it already uses for distinguishing forwards from futures. (24) Second, courts should continue to follow the same path, applying the law to swaps the same way it has applied the law to forwards. (25) In addition, Part IV argues that the courts should defer to the CFTC to the extent possible, allowing the agency adequate flexibility to regulate swaps, especially because swaps have never been regulated before. (26) That is to say, the court should leave the CFTC some wiggle room. (27)

   Lastly, and most importantly, Part IV recommends corporations familiarize themselves with the new regulatory definitions and safe harbors. (28) Corporations that have a choice in the matter ought to privately negotiate forward contracts that fall outside the scope of the Dodd-Frank changes to the CEA. In any event, this Note aims to provide a framework for determining how the CFTC distinguishes between forwards and swaps. Using this framework, companies can structure their transactions in the most advantageous way.

2. BACKGROUND

   Congress passed Dodd-Frank in 2010, in which it authorized the CFTC to regulate certain swaps. The CFTC, along with the Securities Exchange Commission (SEC), issued the Product Definitions Rule in the summer of 2012. (29) In both, consistent with historical practice, Congress and the CFTC excluded nonfinancial commodity forwards from regulation. In order to understand what this means and why they did so, an explanation of derivatives is necessary.

   1. Derivative Instruments

      According to Steven L. Schwarcz, one of the leading scholars on the financial crisis, "[d]erivatives are chameleon-like, in that they easily can change form and appearance." (30) This variety not only makes it difficult to determine what transactions ought to be regulated; it also makes it hard for the general reader to understand what derivatives are in the first place. Yet, derivatives seem to be involved in many of the economic scandals that make headline news. (31) Derivatives, for example, have played a role in several scandals ranging from Enron in 200132 to the Orange County bankruptcy during the 2008 financial crisis. 33 But what are these financial instruments exactly? This Part will discuss just three derivative instruments--forwards, futures, and swaps--in order to provide a foundation for understanding the context in which administrative agencies, including the CFTC, regulate them.

      1. Forwards

         In the financial world, a "spot transaction" is one that is settled immediately, or on the spot. (34) The parties might exchange, for example, cash for some quantity of an asset. It applies in the context of a commodities market the same way it applies at the gas station: you pay whatever price is posted that day. If you were in the electricity generation business, you might pay the spot market price for coal or natural gas. (Ultimately, the price of these inputs gets reflected in the retail price that households pay.)

         A "forward transaction," in contrast, is one in which the parties reach an agreement to settle the transaction at some time in the future. (35) In a forward contract for a nonfinancial commodity like coal, (36) settling would include delivery and payment. Unlike a spot transaction, the parties negotiate a mutually acceptable price so that rather than later paying the market price or "spot" price, the purchasing party pays the negotiated price. (37)

         Such contracts have traditionally proven useful in agricultural commodity markets because of the timing involved. It allows, for example, a corn farmer to lock in a price for his corn before he plants it, rather than hoping that the market price will be acceptable after he harvests and is ready to sell. (38) Otherwise, he takes a risk that the price will fall, and he will have to sell his corn at a loss. Conversely, a corn buyer could enter a forward contract to minimize the risk that the price of corn will skyrocket, forcing him to buy at a premium.

         This economic principle applies to electricity markets as well. Suppose, as another example, that a utility company expecting the next summer to be very hot entered into a forward contract with a generation and transmission company to make sure that it had sufficient electricity to meet its load, or demand. (When it is hot, consumers use electricity to cool buildings.) The utility can negotiate a price for the electricity it thinks it will need next summer, and in doing so, remove the uncertainty involved if it waits and buys electricity on the spot market. That is, it can hedge against the risk of unfavorable weather conditions. (39)

      2. Futures

         Like forwards, futures are contracts in which the price and delivery date are set up front. (40) Forwards are privately negotiated, though. Unlike forwards, futures are standardized and traded on exchanges. (41) Futures traders, rather than agreeing to take delivery of the underlying asset (whether it be a nonfinancial commodity like electricity or a financial...