Energy Companies Scramble to Comply With New Swaps Rules

The bulk of the Dodd-Frank Act was aimed at policing too-big-to-fail banks and lowering the risks that large financial institutions contribute to the financial system. But plenty of smaller companies and those far from the bustle of Wall Street are getting caught in its regulatory nets too.

While new derivatives trading rules are aimed at bringing more transparency to the hedging activities of financial firms, energy companies—large and small, and of all specializations—are also staring at fast-approaching deadlines for a slew of new requirements and disclosures, since most of them engage in hedging activities that fall under the new regulations.

The final rules to implement Title VII of the Dodd-Frank Act requires that energy swaps fall under new rules soon to be enforced by the Commodity Futures Trading Commission. The first deadline that oil, gas, power, and other utility companies need to heed is Oct. 12, the date by which appropriate entities will need to register as swap dealers and start tracking position limits.

“The challenge for swap dealers is monumental,” says Bill Hederman, a director in Deloitte's Enterprise Risk Service practice who focuses on energy regulatory compliance. “They have so much to do and so little time to get it all done.”

The requirements for energy companies are two-fold: One, if guidelines establish them as swap dealers (SD) or major swap participants (MSPs), all swap transactions will need to be cleared through a CFTC-registered derivative clearing organization. Second, there are strict, designation-specific, requirements for recordkeeping, including capturing real-time transaction data, and capital, margin, and position limits.

Even if a utility doesn't meet the definitions and thresholds set by the final SD or MSP definitions, many will still likely face new reporting, recordkeeping, and retention requirements.  “It affects everyone who does energy trading,” Hederman says.

Julie Luecht, a principal in KPMG's Financial Risk Management practice, says there have been numerous complaints that the rules are overly broad and lack detail. “This is new to energy companies from the standpoint of having strong regulations from these particular regulators,” she says. “When you compare energy companies to banks—which have entire departments dedicated to this type of regulation and understand how to interpret these rules and apply them to their processes—it is certainly more challenging for the utilities.”

Not only do small energy utilities need to comply with rules that were largely aimed at big banks and bulk derivatives traders, they don't have much time to put the systems in place to capture and report the required data. Lisa Epifani an attorney with Van Ness Feldman, a law firm that specializes in energy regulation, says one of the reasons many utilities feel pressure is the order in which the rules were finalized: “the key rulemakings that everybody needed to know first, dealing with what is a swap, came out last.”

“It is hard to prepare for what compliance may be when you are not even sure if your transactions are going to be jurisdictional or not,” she says. “A lot of people, up until 2010, lived with energy commodities being exempt. They just didn't worry about it before, but it's a new world now.”

“A lot of people, up until 2010, lived with energy commodities being exempt. They just didn't worry about it before, but it's a new world now.”

—Lisa Epifani,

Lawyer,

Van Ness Feldman

Many in the energy and agriculture industries initially thought an end-user exemption would spare them from the regulatory changes. “That was just a misunderstanding,” Hederman says. “Most companies have now come to understand that they will have to do something. It is a complicated and difficult area that people tended to put off if they could. Now, it is really beyond the point of prudent action to still be putting it off.”

Language in the final rule on what types of transactions would be considered swaps and therefore subject to the new regulations came as a surprise to some utilities. Epifani explains that a paragraph in the final rule noting that transactions with two-part rate structures will be defined as commodity options subjected many transactions that energy companies use to hedge to the new regulations. 

“If you look at most of the Federal Energy Regulatory Commission's gas regulations, it requires them to be in two-part rates,” she says. “All of a sudden, gas transactions [and others] that wouldn't ever have been considered swaps are described exactly that way in the rule. If you have a two-part rate where you pay a demand charge and then further payment is required as sort of a usage fee, [it's]  a commodity option.”

DODD-FRANK ENERGY MANDATES, TIMING

Below is a timeline for Dodd-Frank rule implementation:

Among the thousands of pages of the Dodd-Frank Act, Congress mandated provisions that will have important implications for energy companies and other companies that transact in energy. These new rules and requirements are in various stages of completion but many were finalized as of January 2012. The remaining rules are anticipated to be completed in Q2-3 of 2012.

Finalized as of Feb. 29, 2012

Data Recordkeeping and Reporting

External Business Conduct Standards

Real-Time Reporting

Whistleblower Rules

Larger Trader Swap Reporting

Disruptive Trading Practices

Anti-Manipulation

Core Principles and Duties of Swap Data Repositories (SDRs) and Derivative Clearing Organizations (DCOs)

FBOT Registration

Position Limits (including bona fide hedge exemption)

Swap Dealer and MSP Registration

Internal Business Conduct Standards

First Half of 2012:

Entity Definitions

Product Definitions/Commodity Options

End-User Exception

Capital and Margin

Client Clearing Documentation and Risk Management

Registration and Core Duties of Swap Execution Facilities (SEFs)

Segregation for Uncleared Swaps

Straight-Through Trade Processing

Conflict Minerals Disclosures

Disclosure of Payments to Governments by Resource Extraction Companies

Source: Deloitte.

Last-Minute Change

Making matters worse, this language wasn't in the proposed rule. “It is brand new,” Epifani says. “We had no way of opining on it or offering comments to steer the CFTC to a different direction. I think what the CFTC rightly would capture under a two-part rate is where a company might put down a small amount of money to hold space in a pipeline and then pay a lot of money on the second part of the transaction to actually exercise that right. That is an option. In the FERC world, you pay a large part upfront and then a nominal fee as the second part of the rate for the actual usage [such as maintenance and fuel charges]. It is not in any way an option premium, even though that's what the rule says.”

Hederman's advice for energy companies preparing for their new responsibilities is to first seek out expert legal counsel to help conform to rules and interpret those that remain ambiguous. He also suggests a dedicated “Dodd-Frank implementation team,” a multi-disciplinary committee that needs to include legal, compliance, and IT expertise from within the company.

It is also important to document all the decisions you make, whether they are ones made with counsel or ones you are making on your own. “You need to be looking at your transactions portfolio, figuring out what you need to be reporting on, and what you need to be tracking for the position limits and what you can be netting out,” he says. “You may not get all those decisions correctly. There is a fair amount of uncertainty that even somebody proceeding in a good faith basis could encounter here, but you have to make your best judgment on it and move forward.”

Hederman says companies that already have well organized trading operations could probably get through most of what need to get done for SD or MSP requirements with about one professional year's worth of effort. “If you put a six-person team on this and have them devote two months to this, you could probably get a lot of this done,” he says. “Some of our clients have found that they have records in different trading systems, and they are not necessarily compatible. That will take time, so it is much better to look, know that, and start dealing with it now.”

A KPMG report, “Dodd-Frank Title VII Is Reengineering Energy Swaps,” advises companies to evaluate their current recordkeeping and data management capabilities from both an IT and business process perspective.

Source: Deloitte.

Luecht adds that there are some unique twists to reporting requirements.  For example, companies that are neither SDs nor MSPs, if they are transacting with another non-MSP or non-SD entity, will have to determine which side will handle reporting. Because of this, there needs to be a system in place to communicate with the reporting party and confirm that they submitted the information to the swap dealer.

What happens if a company falls short of the regulatory demands placed on them? “My take is that if you are following the spirit of the rules, you will probably be given a reprieve early on,” Luecht says. “However, as time goes on and more information comes out through enforcement actions and interpretations get a little clearer, there may be changes companies have to make to their first interpretation of the rule.”

“For about two years it is going to be a very challenging period as energy companies come to grips with what the implications of all these rules are, understand how their transactions fit into the swap/not-a-swap buckets, and comply with the data and recordkeeping rules that might be applicable,” Epifani says. “I don't see the CFTC running out and trying to enforce everything on Oct. 13. They are not in a ‘gotcha' mode, at least not in the energy company space.”