Retail Power and Natural Gas Suppliers: Subject to CFTC Regulation?
September 18, 2003
Today’s quasi-deregulated retail natural gas and power markets seem to present competitive suppliers and regulated utilities offering market-price alternatives (collectively, suppliers) with the opportunity to offer their retail customers pricing structures limited only by their imaginations. Or do they? The use of commodity futures, exchange-traded commodity options or over-the-counter commodity options (collectively, commodity interests) to adjust gas or power prices may raise commodity regulatory issues when undertaken in connection with retail customer gas or power supply programs (programs). Referring to commodity interests when marketing a program, if not done carefully, or appearing to provide commodity trading advice can raise U.S. Commodity Futures Trading Commission (CFTC) registration issues. Failure to register when required can lead to civil and even criminal sanctions (for willful violations). However, properly structured and carefully monitored programs can avoid CFTC jurisdiction.
Many suppliers’ programs offer several pricing options. Examples include fixed monthly pricing irrespective of customers’ commodity usage; fixed pricing per-commodity unit with variable monthly costs based on customers’ commodity usage; variable, market-plus-costs (e.g., hedging and transmission/transportation costs) pricing; and programs capping customers’ per-commodity unit prices. The manner in which suppliers reference commodity interests in, and market, their programs determines whether commodity regulatory issues must be considered.
CFTC registration issues can arise under the Commodity Exchange Act (CEA) and CFTC rules if a customer believes that a supplier’s commodity interest positions are for the customer’s account; a supplier recommends a customer’s use of futures or options; or a customer believes that it has purchased an interest in a commodity pool.
It is not always clear whether programs using commodity interests are outside the scope of the CFTC’s jurisdiction. For example, the CFTC staff has in one instance characterized as outside its jurisdiction a forward contract incorporating option-like features to provide a commodity producer a minimum price guaranty. However, both parties to that transaction were commercial parties; the CFTC has not addressed such contracts in the context of a program involving residential customers.
The CFTC’s Office of General Counsel (OGC) has permitted the use of commodity interest prices as a component of cash or forward (deferred delivery) contract prices without requiring CFTC registration in any capacity. In a 1985 interpretation, OGC characterized as a forward contract (and, thus, outside the CFTC’s jurisdiction) an agreement requiring a commodity producer to deliver a specified quantity and grade of a commodity to a dealer at a specified future date. Under the agreement, the final price was not established but the method to determine it was, which in some cases could be a futures contract price or the “basis” (the difference between a futures contract price and the spot price for the same commodity). The agreement also stated that delivery to the dealer/merchant was mandatory and that the dealer/merchant would guarantee the producer a minimum price for the commodity in return for a premium deducted from the final price paid for the commodity at maturity.
OGC “recognize[d] that these contracts have characteristics of a cash-settled put option” (which are within the CFTC’s jurisdiction and subject to certain restrictions on sales) but based its conclusion on the fact that the agreement in question was a forward contract on its view that “legally[,] the contract’s predominant feature is its use by producers and merchants to market a commodity through actual delivery.” A key assumption underpinning OGC’s analysis, however, was that both counterparties were in the business of buying and/or selling the commodity. That is not the case with suppliers’ residential customers.
A supplier’s conduct can cause it to resemble a futures commission merchant (FCM), commodity trading advisor (CTA) or commodity pool operator (CPO) in connection with its program if it is not careful. FCMs, CTAs and CPOs are required to register with the CFTC absent an applicable exclusion or exemption. An entity acting as an unregistered FCM, CTA or CPO is subject to civil penalties (and criminal penalties, for willful violations).
If a supplier appears to be trading futures or exchange-traded options for other parties (e.g., their retail customers), the CFTC may consider the supplier an FCM (that is, a futures broker). Marketing materials or communications that give the retail customer the impression that it has a stake in the profit or loss on a commodity interest could put a supplier at risk of being characterized as an FCM. For a supplier to avoid CFTC registration in connection with a program, commodity interest trading to hedge the supplier’s exposure must be for the supplier’s own account and not for the account of any of its customers, and the supplier’s marketing materials and activities must reinforce, not obscure or contradict that fact.
Providing “advice” (a term that the CFTC defines broadly) about commodity interest trading generally requires registration as a CTA. A supplier that uses marketing materials (including historical or predictive price analyses) discussing the beneficial role of commodity interests (e.g., “our program’s transactions in commodity interests will save you money or lock in your price”) runs the risk that it may be viewed as a CTA. Various exemptions from CTA registration may be available, including one which exempts cash market commodity sellers whose commodity trading advice is solely incidental to the conduct of their cash market business. The CFTC staff generally has applied this exemption very narrowly. Thus, to the extent program materials distributed must mention commodity interests at all, such materials should make clear that the supplier is using the commodity interests for its own account and should not express or imply any direct link between the supplier’s commodity interest trading and the customer’s profit or loss.
A person or entity that pools multiple persons’ funds and uses those pooled funds to trade commodity interests on behalf of third persons generally is considered a CPO and must register with the CFTC. Generally, the entity that runs the day-to-day operations of a pool, can hire and fire its CTA or FCM, or handles or exercises control over the funds of persons who invest in commodity pools is required to register as a CPO. The CPO is usually the board of directors or certain officers of a corporate pool. If the CFTC or a court concluded that a program was a pool (based, for example, on program contracts or marketing materials implying that, through interests in a collective investment or hedging vehicle, customers have an interest in commodity interests traded by a supplier), the supplier’s board of directors could conceivably be required to register as CPOs. The supplier could also be found to be in violation of CFTC regulations requiring CPOs to operate pools as legal entities separate from the CPO. Therefore, when promoting a program, it is critical that the supplier not lead a customer to believe that it has an interest in the program’s commodity interests, and the supplier must structure the program so customers do not in fact have such interests.
Today’s retail gas and power supply programs have many permutations, some of which can raise commodity regulatory issues. The appropriate legal analysis involves a number of variables and is fact-specific.
