CFTC Representations
Introduction
The U.S. Commodity Futures Trading Commission (“CFTC”) has jurisdiction over ALL products traded on any US exchange (this captures virtually all financial products, except for foreign jurisdiction specific products that are not traded in the US). All ISDAs must include certain representations in the ISDA Schedule to ensure that the ISDA Master Agreement and the underlying Transactions fall into a safe harbor exempting the ISDA Master Agreement / Transactions from regulation by the Commodity Futures Trading Commission (“CFTC”) and are not deemed illegal off-exchange transactions.
Background
In order to comply with U.S. Commodity Futures Trading Commission (“CFTC”) regulations, we include two market standard representations, “Eligible Contract Participant” (“ECP”) and “Eligible Commercial Entity” (“ECE”), in our ISDA Schedule and other Master Agreements. The United States Commodity Exchange Act (“CEA”) was passed in 1936 and provides for federal regulation of all commodities and futures trading activities and requires that all futures and commodity options be traded on organized exchanges, and its primary enforcer, the CFTC, regulates all futures markets in the United States in which commodities are traded. The CEA defines “commodity” very broadly (see definition below, emphasis added).
7USC.1a.Definitions. (4) Commodity. The term “commodity” means wheat, cotton, rice, corn, oats, barley, rye,
flaxseed, grain sorghums, mill feeds, butter, eggs, Solanum tuberosum (Irish potatoes), wool, wool tops, fats and
oils (including lard, tallow, cottonseed oil, peanut oil, soybean oil, and all other fats and oils), cottonseed meal,
cottonseed, peanuts, soybeans, soybean meal, livestock, livestock products, and frozen concentrated orange juice, and
all other goods and articles, except onions as provided in section 13-1 of this title, and all services, rights, and
interests in which contracts for future delivery are presently or in the future dealt in.
This could include a variety of financial products that we do not typically think of as “commodities” such as interest rates and currencies, potentially pulling in USD swaps and / or USD foreign exchange transactions.
The CEA provides that it is unlawful to enter into or execute a futures contract unless it was traded on, or subject to the rules of, a board of trade which had been designated by the CFTC as a contract market (a regulated commodity exchange, e.g. the NYMEX, CBOT etc.). Under the laws of the various U.S. states, an unlawful or illegal contract is void and unenforceable.
To promote certainty for the markets and to distinguish between on-exchange futures contracts and over-the-counter derivatives transactions, the United States government enacted the Commodity Futures Modernization Act of 2001 as an amendment to the CEA, clarifying certain defined terms and exemptions for over-the-counter derivative transactions. Any over-the-counter derivatives transactions in a “commodity” could be considered an illegal off-exchange Futures contract unless the transaction and the parties to such transaction fall into one or more of the categories of trades that are exempt from regulation as a futures contract. Specifically, certain derivative transactions may only be entered into by “eligible contract participants” to be exempt from regulation as a futures contract.
CFTC Jurisdiction and the Commodity Futures Modernization Act
Whether a transaction is subject to CFTC jurisdiction depends upon the type of contract being negotiated. The CFTC has exclusive jurisdiction over transactions involving sales of a commodity “for future delivery” and commodity option transactions.
Rather than attempt to draw definitive distinctions between various types of commodity contracts, in 2000, the U.S. Congress decided to increase the certainty of OTC derivative contract enforceability by excluding or exempting certain contracts from CFTC regulation and enacted the Commodity Futures Modernization Act of 2000 (“CFMA”), created, among other things, broad safe harbors for OTC transactions in Excluded Commodities and Exempt Commodities, provided that the contract is entered into solely between Eligible Contract Participants (“ECP”) and is not entered into on a trading facility.
CFTC jurisdiction applies to the underlying product type or transaction and is applicable whenever we enter into a transaction referencing a US commodity (as broadly defined by the CEA).
Points to note on Jurisdiction
- The governing law of an ISDA Master Agreement or Transaction Confirmation, and the jurisdiction of incorporation of either party does not affect the applicability of the CEA.
- There are certain limited circumstances where the CEA and CFTC regulation does not apply. However, it is difficult to monitor and a firm's systems may not set up in such a way to ensure compliance with these particular exceptions.
- Accordingly, we request the inclusion of these provisions in all ISDA Master Agreements.
Points to note on New York branch
- Please refer to guidance regarding the inclusion of the New York branch as this will affect whether the CFTC representations need to be included in the ISDA here:
- Multibranch Parties - ISDA Knowhow.
- See also Multibranch parties.
ECP and ECE Representation
The need for a reasonable belief
To further ensure the enforceability of excluded and exempt OTC commodity contracts, Congress included the following provision in the CEA:
§ 25 (a)(4) Contract enforcement between eligible counterparties.— No agreement,
contract, or transaction between eligible contract participants or persons
reasonably believed to be eligible contract participants, and no hybrid
instrument sold to any investor, shall be void, voidable, or unenforceable,
and no such party shall be entitled to rescind, or recover any payment made
with respect to, such an agreement, contract, transaction, or instrument under
this section or any other provision of Federal or State law, based solely on the
failure of the agreement, contract, transaction, or instrument to comply with
the terms or conditions of an exemption or exclusion from any provision of this
chapter or regulations of the Commission.
Eligible Contract Participant representation
Accordingly, the Eligible Contract Participant (“ECP”) representation is included in our ISDA Schedule to ensure we can meet the standard of having a “reasonable belief” that our counterparty is an ECP, and therefore the transaction in question is considered to be of a class of transaction to be exempt or excluded from the regulatory framework of the CEA and its primary enforcer, the CFTC.
The definition of Eligible Contract Participant includes most entities having, or being guaranteed by entities having, total assets exceeding USD 10 million, ERISA plans having total assets exceeding USD 5 million, governmental entities, and some other categories of investors.
ECP Rep wording
Additional Representations. Each party will be deemed to represent to the other party on each date on which a Transaction is entered into that: ...
... it is an “eligible contract participant” as such term is defined in the Commodity Exchange Act, as amended 7 U.S.C. § 1 (a) (12); and
A counterparty may provide a factual representation regarding their status that satisfies the definition of ECP, for example:
[Counterparty] has, or is guaranteed by an entity that has, total assets exceeding $10,000,000.
Eligible Commercial Entity representation
The Eligible Commercial Entity (“ECE”) representation is needed in the ISDA Master Agreement for any entity that intends to transact on a principal to principal basis in an Exempt Commodity on an Electronic Trading Facility (an electronic trade matching and execution platform for OTC derivative transactions) in order to ensure the transactions will be exempt from most provisions of the CEA.
ECEs are subset of ECPs including, among others, entities who have a demonstrable ability to make or take delivery of the underlying commodity, or to incur risk in addition to price risk related to the commodity, or are dealers regularly providing risk management or hedging services to or engaging in market-making activities with other eligible commercial entities.
ECE Rep wording
Additional Representations. Each party will be deemed to represent to the other party on each date on which a Transaction is entered into that: ...
... it is an “eligible commercial entity” as such term is defined in the Commodity Exchange Act, as amended 7 U.S.C. §1(a)(11).
This one is harder to boil down to a factual rep, but note that it may be removed as a result of Dodd Frank.
Consequences of failure to meet the ECP or ECE requirements
If the parties do not meet the applicable ECP and/or ECE requirement the commodity transaction is considered an illegal off-exchange transaction.
There may be fines from the CFTC and the trade could be considered void.
The CFTC Enforcement Division is able to impose significant fines, up to $1MM per day per violation of the CEA. To date, we are not aware of any fines being imposed at this level for this issue but the CFTC has only relatively recently acquired the ability to impose these hefty fines and we are seeing some very large3 fines being imposed for other violations.
Additionally, there are US cases were a party to a trade has walked away from the deal claiming it was an illegal off-exchange transaction.