OTC Derivatives — Legislative and Regulatory Developments

Legislative Developments

The House Financial Services Committee and House Committee on Agriculture have passed competing versions of a bill to regulate over-the-counter (OTC) derivatives. The Financial Services Committee approved its bill, H.R. 3795, on October 15, 2009. The Committee on Agriculture approved its bill, in the nature of an amendment by substitution to H.R. 3795, on October 21, 2009. Both bills are intended to provide comprehensive regulation of OTC derivatives markets, swap dealers, and major swap participants through amendments to the Commodity Exchange Act (CEA) and federal securities laws.

The bills follow the general outline of the U.S. Department of the Treasury's OTC legislative proposal issued on August 21, 2009, and the "Principles for OTC Derivatives Legislation" that Rep. Barney Frank (D-Mass.), Chair of the Financial Services Committee, and Rep. Collin Peterson (D-Minn.), Chair of the Committee on Agriculture, jointly issued on July 30, 2009. There are important differences, though, across the three bills in their approach to coordinating OTC regulation between the SEC and the U.S. Commodity Futures Trading Commission (CFTC); trading of standardized swaps on a centralized regulated exchange or swap execution facility; clearing of standardized swaps (required under all three); and end-user exemptions from mandatory clearing.

The provisions to mandate the clearing of standardized swaps are drawing particular attention from commercial end-users, including those in the energy and agriculture fields, to assure that such provisions, if enacted, do not interfere with legitimate hedge strategies using OTC swaps, which are often more cost effective to maintain than strategies using cleared derivatives. All three bills include indirect exemptions from mandatory clearing where one party is a hedger, unless that party otherwise meets the definition of a swap dealer or major swap participant. The Treasury bill, though, limits hedging to positions considered hedges under Generally Accepted Accounting Principles, and the Committee on Agriculture bill imposes the condition that the end-user must demonstrate to the CFTC how it meets its financial obligations under its non-cleared swaps.

The clearing provisions will likely generate ongoing legislative debate. CFTC Chairman Gary Gensler has weighed in with a public call for a narrowing of the end-user hedge exemption. The legislative proposals also raise concerns about the potential for overlap and conflict of CFTC's jurisdiction, on the one hand, and that of the Federal Energy Regulatory Commission or the Public Utility Commission of Texas, on the other hand, over Regional Transmission Organization (RTO) markets.

CFTC Regulatory Developments

The CFTC recently issued a number of releases soliciting comments on whether various energy-related contracts offered for trading on the IntercontinentalExchange, Inc. (ICE) perform significant price discovery functions and should be designated as "significant price discovery contracts." Three of the releases, published on October 6, 2009 (74 FR 51261 and 74 FR 51264) and October 26, 2009 (74 FR 54966), cover various electricity-related contracts such as SP-15 Financial Swap Real Time LMP — Peak Daily contract, NP-15 Financial Day-Ahead LMP — Peak Daily contract, and the PJM WH Real Time Peak Daily Contract. The other releases initiate the designation review process for numerous natural-gas-related contracts traded on ICE. Prior to this flurry of activity, the CFTC had considered designating only one ICE contract, the Henry Financial LD1 Fixed Price contract, as a significant price discovery contract, and designated the contract as such pursuant to an order appearing in the Federal Register on July 30, 2009 (74 FR 37988).

ICE is regulated as an exempt commercial market under the Commodity Exchange Act (CEA). Under rules adopted by the CFTC in March 2009, ICE will be required to adopt spot month position limits for any of the contracts that the CFTC designates as significant price discovery contracts, but only if trades in the contracts are cleared (the CFTC deferred rulemaking with respect to position limits / position accountability for non-cleared ICE contracts), but ICE also may adopt hedge exemptions from the limits. ICE also will have to adopt position accountability levels (or could adopt more stringent position limits) for the contracts for non-spot months and all months combined, and implement large trader position reporting for the contracts. ICE will have 30 days to take these actions following the CFTC's designation order for a contract (90 days for the first ICE contract so designated, the Henry Financial LD1 Fixed Price contract). ICE may allow a 90-day grace period from the date of its implementation of position limits for market users to reduce their positions (absent a hedge exemption) with the limits.

Separately, in a speech on October 27, 2009 before the Natural Gas Roundtable, CFTC Chairman Gensler stated that the CFTC should consider exercising its authority under the CEA to adopt position limits for futures contracts to set limits "to guard against excessive concentration in the energy futures markets." Although not unprecedented — CFTC-imposed position limits have existed for many years for a number of agricultural futures contracts — this would be an extraordinary step. The chairman's comments may be intended to pressure the New York Mercantile Exchange (NYMEX) to expand the reach of its current position limits for its energy contracts on its own; the NYMEX limits typically apply only during the last several trading days of the spot month. NYMEX, and its parent, the CME Group, Inc. (which also owns the Chicago Mercantile Exchange and Chicago Board of Trade), may, in turn, press the CFTC to move forward with rulemaking to impose obligations on exempt commercial markets — notably ICE — to adopt the position limits for its non-cleared significant price discovery contracts.


DOE Issues New Loan Guarantee Program Solicitation With Details of the Financial Institution Partnership Program

On October 7, 2009, the U.S. Department of Energy (DOE) announced that it would provide up to $750 million in loan guarantees to support the development of conventional renewable energy generation projects. The new solicitation invites private-sector participation through the creation of the Financial Institution Partnership Program (FIPP). To receive funding under this solicitation, a proposed project must commence construction by September 30, 2011.

The solicitation invites applications for partial risk-sharing loan guarantees under the DOE's loan guarantee program in support of debt financing for renewable energy systems that generate electricity or thermal energy by using commercial technology. Unlike prior loan guarantee program solicitations, under the FIPP solicitation, proposed borrowers and project sponsors do not apply directly to the DOE but instead work with eligible lenders.

The solicitation seeks applications for conventional projects utilizing commercial technology. This is a departure from previous solicitations, which focused on new or innovative technologies. DOE anticipates that this solicitation will support as much as $4 billion to $8 billion in lending to eligible projects, including the following categories of generation facilities:

  • Wind
  • Closed-loop biomass
  • Open-loop biomass
  • Geothermal
  • Landfill gas
  • Trash-to-energy
  • Hydropower
  • Solar

The guarantee percentage is limited to no more than 80 percent of the maximum aggregate principal amount of, and interest on, the guaranteed obligation. DOE will not assume pre-construction risks. Finally, the project debt must obtain a credit rating of at least "BB" from Standard & Poor's or Fitch or "Ba2" from Moody's as evaluated without the benefit of any DOE loan guarantee.

Applications must be filed in two parts, with the Part I application filed any time before Part II is submitted. The first of the rolling Part II deadlines is November 23, 2009.

The full solicitation announcement is available on the Loan Guarantee Program Web site at http://www.lgprogram.energy.gov/CTRE.pdf. For regularly updated information on available stimulus funds and programs, see Foley's ARRA Summary page at http://www.Foley.com/arraenergy.


Massachusetts Preparing to Issue Ocean Management Plan

On November 23, 2009, the public comment period will end on a first-of-its-kind draft ocean management plan unveiled by the Commonwealth of Massachusetts on July 1, 2009. The plan is being developed pursuant to the Oceans Act of 2008, which requires the Commonwealth's Secretary of Energy and Environmental Affairs to develop a comprehensive science-based plan to manage development in its state waters, balancing natural resource preservation with traditional and new uses, including renewable energy.

With the assistance of a 17-member Ocean Advisory Commission, composed of state legislators, agency heads, an expert in the development of offshore renewable energy, and representatives of commercial fishing organizations, environmental groups, and regional planning commissions as well as a nine-member Science Advisory Council comprising scientists with expertise in marine sciences and data management, the secretary is required to issue a final plan by December 31, 2009. Public hearings were held throughout the month of September. Once the comment period ends, the secretary must proceed to finalize the plan. Upon final adoption, the ocean plan will be incorporated into the existing coastal zone management plan and enforced through the state's regulatory and permitting framework.

The Oceans Act specifically amended the existing Ocean Sanctuaries Act to allow for the siting of "appropriate-scale renewable energy facilities" in state waters except for the Cape Cod Ocean Sanctuary. The Ocean Sanctuaries Act had prohibited the siting of such facilities in most state waters. The draft ocean plan, as required by the Oceans Act, identifies appropriate locations for electric generation facilities and other uses as well as protected areas considered too environmentally sensitive for development. Overall, the draft plan designates two percent of state waters for commercial wind energy facilities.

State waters extend to a distance of only three miles offshore. Notably, the Cape Wind energy project is located in federal waters in Nantucket Sound and will not benefit from the adoption of the ocean plan. Nevertheless, the plan represents a significant step forward in facilitating the development of offshore renewable energy projects by providing guidance on siting and a framework for permitting and approval of such projects in the waters offshore of Massachusetts.


Lawsuit Claims That Utility Poles Are Hazardous to the Environment

In a first-of-its-kind litigation, the Ecological Rights Foundation (ERF) has sent notices of alleged environmental violations to 15 companies, including major telecom companies such as AT&T, Verizon, Sprint/Nextel, along with cable giant Comcast Corporation and Pacific Gas & Electric Company (PG&E), over the treatment of those companies' utility poles treated with wood preservative, pentachlorophenol (penta). The lawsuit involves more than 300,000 utility poles — all of the poles in four counties in Northern California: Alameda, Contra Costa, Marin, and San Francisco. ERF claims that the penta leaks from the poles and contaminates the ground and nearby waterways, including San Francisco Bay.

This lawsuit potentially has far-reaching implications. Millions of utility poles throughout the country are treated with penta or other similar chemical preservatives. The preservatives are necessary to keep the utility poles in service and to keep the electricity and telephone service flowing to the homes and businesses in this country. The environmental impact of the penta-treated poles were examined in great detail by the U.S. Environmental Protection Agency (EPA) when the EPA approved the use of penta-treated wood poles as utility poles. By approving the use of penta, the EPA found the penta did not cause the significant environmental harm claimed by ERF.

If successful, the use of wood preservatives would, notwithstanding EPA's decision, be seriously hampered since all utilities would be at risk for similar litigation. It also could establish the far-reaching precedent that EPA's approval of products could be routinely second-guessed in private litigations. Such litigation would no doubt become a blueprint for similar litigation nationwide, with the goal of ending the use of treated poles in this country.

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