5 Dodd-Frank Reforms That Keep Energy Attys Up At Night - Law360

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5 Dodd-Frank Reforms That Keep Energy Attys Up AtNightBy Keith Goldberg

Law360, New York (September 11, 2014, 2:13 PM ET) -- Energy companies rely on derivatives andother complex financial products to hedge against the risks of their inherently volatile businesses.
But the Dodd-Frank Act is making those financial products subject to stricter regulations, thrustingenergy firms into a brave new world of increased — and not necessarily welcome — complianceand the costs that accompany it.
“The energy companies have been saying, ‘We're not the AIGs or Lehman Brothers that are coming
up with these complex derivatives, we're just the ones that use them to hedge risks in ourbusiness,” said Perkins Coie LLP partner Jason Kuzma. “It's been a culture change more thananything.”
Most of the Dodd-Frank rules affecting energy firms — primarily issued by the U.S. Commodity
Futures Trading Commission — are already on the books either in proposed or final form.
“There are few important ones left, but we're really in the phase of implementation andcompliance,” said Stephen Humenik, a former counsel to former CFTC Commissioner Scott O’Malia
who now leads Covington & Burling LLP’s futures and derivatives practice. "For a global energy
company, the biggest question is: How do you put in place a global compliance program thatcovers all bases?"
Here, attorneys share with Law360 five aspects of Dodd-Frank that are causing the most concern
for energy firms and their counsel:
Position Limits
Attorneys say it’s the most burning Dodd-Frank issue for energy firms: the CFTC's revised proposal
in November, which sets limits on speculative positions in 28 physical commodity futures aswell as swaps that are "economically equivalent" to those contracts.
“One positive sign from the CFTC is that the comment period was reopened twice,” Humenik said.
“That being said, there is a lot of criticism over the proposed rule. It doesn't adequately address
how energy firms manage the risk of their commercial operations."
The proposal calls for strict limits on the types of hedging transactions that would be exempt fromthe position limits — known as bona fide hedging exemptions — which could make it harder andmore expensive for energy companies to guard against price swings, attorneys say.
“What people do today doesn't appear to match what the commission has proposed,” said David
Perlman, a Bracewell & Giuliani LLP partner.
That includes strategies such as dynamic hedging as well as hedging across an entire energy
portfolio.
“You can’t necessarily match each megawatt to each piece of steel in the ground,” Baker Botts LLP
partner Elaine Walsh said. “It’s looking across someone’s entire generation fleet or electrical load;

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5 Dodd-Frank Reforms That Keep Energy Attys Up At Night - Law360

you can’t just evaluate at some static point in time.”
Trade Options
Energy companies frequently enter into contracts such as the future delivery of electricity that
contain so-called trade options — for example, an electricity buyer having the option to buy
additional megawatts at a certain point in time.
These option-laden contracts initially fell under the CFTC regulation under Dodd-Frank, but when
the commission issued its final swap definition in 2012, it included a seven-part test that energy
firms could use to determine whether those contracts qualified as swaps and were subject toDodd-Frank regulation. A contract that satisfied all seven parts would qualify as a physical forward
contract and be exempt from Dodd-Frank swaps regulation.
But attorneys say the seventh prong of the test — which says that the options in contracts must
be based on factors outside the parties’ control, such as physical or regulatory requirements — ismurky and could sweep contracts containing options like the ability to purchase power if it’scheaper into swaps territory and stricter regulation.
“The definition of the seven-prong test still creates uncertainty over many different types of what
would otherwise be considered straightforward physical contracts,” said Michael Sweeney, aSutherland Asbill & Brennan LLP partner.
What’s more, despite their physical, nonfinancial nature, trade options are included in the CFTC’sposition limits, creating an additional, unnecessary restraint on the hedging deals available toenergy firms, attorneys say.
“The inclusion of those trade options within position limits is really viewed as not within the intentof Dodd-Frank,” Winston & Strawn LLP partner Michael O’Brien said. “These are not speculativetransactions, they are transactions that would physically settle.”
The CFTC’s Swap Definition
The uncertainty over the seventh prong of the CFTC’s seven-part swap test underscores a central
issue for energy companies: The commission’s definition of a swap is still unclear, even as it has
unveiled swaps regulations mandated by Dodd-Frank, attorneys say.
“These swaps regulations haven't been applied to commodities yet,” Kuzma said.
That’s a fundamental regulatory uncertainty for energy firms, because they don’t know which
trades they have to publicly report, according to Reed Smith LLP partner Patty Dondanville.
“How do you know you have to keep records of something if you don't know whether it's a swap?”
Dondanville said. “That fundamental question underlies most of the implementation problems thathave bedeviled end users since they began implementing the rules."Capital Rules for Swap Dealers
Energy firms breathed a sigh of relief last week when federal banking regulators proposed a DoddFrank-mandated margin and capital requirements rule for swap dealers conducting swaps
outside of clearinghouses because it won’t require them to post margin for their uncleared swaps.
“It's a form of credit support that typically isn't done by your average energy company — it's doneby trading companies,” Dondanville said.
It’s also essentially in line within the margin rules proposed by the CFTC in 2011. But thecommission has yet to propose its own capital requirements for swap dealers that sidestep
clearinghouses, and energy firms worry that they would ultimately foot the bill for stiffer capitalrequirements for the dealers they work with, attorneys say.

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5 Dodd-Frank Reforms That Keep Energy Attys Up At Night - Law360“The size of energy transaction swaps that are not cleared are significant, because their hedges
are significant,” Dondanville said. “If the swap dealer has to set aside regulated capital to reflectthat not-cleared swap, the bank is going to pass through the cost to the counterparty, meaning
the energy company."
Project finance is one area that could get more expensive, according to Walsh. Companies usually
give liens to underwrite swaps used in financing power plant development, she said.
Capital requirements for swap deals “will go into the prices that are paid for those secured swaps,
and it’s going to affect liquidity,” Walsh said. “How many people are going to be out there offering
those types of terms, or cash, and other forms of liquid security? Even some of the very big power
producers — they don’t have the investment-grade guarantees to back them up.”
The CFTC’s Financial Entity Definition
In mandating tighter financial regulations, Dodd-Frank included a definition of a financial entity.
But attorneys say it’s unclear whether energy companies are covered by that definition, and firms
worry that their hedging activities could sweep them into a regulatory regime that mainly targets
banks and other financial institutions.
“There's no definition of financial entity by the CFTC,” Perlman said. “An electricity company that's
got 15 power plants that sell all their output to a market-facing affiliate that does hedging — thatstand-alone marketing company could be viewed as a financial entity, even though it's not a bankor hedge fund.”Many energy companies have a central trading desk, which does the hedging on behalf of theentire company, according to Sweeney.
“The way the term ‘financial entity’ is defined under Dodd-Frank, the definition cross-referencesbanking law and will pull them into a much stricter regulatory regime and impose more financial
institution-like requirements on energy companies that have trading desks,” Sweeney said. “Theymay not be able to use the end user exemption for swaps and be subject to stricter prudentialrequirements.”--Editing by Jeremy Barker and Philip Shea.
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