Academic journal article Journal of Corporation Law

Corporations and Hedging: Distinguishing Forwards from Swaps under the Commodity Exchange Act Post-Dodd-Frank

Academic journal article Journal of Corporation Law

Corporations and Hedging: Distinguishing Forwards from Swaps under the Commodity Exchange Act Post-Dodd-Frank

Article excerpt

I. INTRODUCTION II. BACKGROUND       A. Derivative Instruments           1. Forwards           2. Futures           3. Swaps       B. The Dodd-Frank Act       C. Product Definitions Rule           1. Nonfinancial Commodity Forwards           2. Embedded Options III. ANALYSIS       A. Statutory Framework and the Product Definitions Rule       B. Distinguishing Forwards from Futures           1. Defining the Scope of the Forward Exclusion           2. Determining Whether a Contract Falls in the Safe Harbor               for Nonfinancial Commodity Forwards           3. Forwards with Embedded Options and Other Provisions       C. Effect on Corporations in the Electric Industry IV. RECOMMENDATION       A. CFTC       B. Courts       C. Corporations V. CONCLUSION 

I. INTRODUCTION

Many authors have offered explanations for what caused the 2008 financial crisis. (1) Some of these authors point a finger at the careless way in which some companies used derivatives. (2) There are several types of derivatives, but the distinguishing feature of a derivative is that its value is derived from something else's value. (3) This could be anything, including, for example, natural gas, coal, or even weather conditions. (4) The contract price for some amount of electricity to be delivered in two years could depend on the market price for coal in two years. In other words, the contract price for electricity would derive from the future market price of coal.

Derivatives are used either to hedge or to speculate. (5) Hedging is a way of managing risk by taking offsetting positions in the market. (6) When an electricity-generating corporation buys coal, it might hedge the risk that the price of coal will rise by purchasing an option to sell coal. By taking this offsetting position, it will be able to sell coal at a higher price if it winds up having to buy coal at a higher price. This allows it both to guarantee itself an adequate supply of inputs while at the same time lowering its vulnerability in the event that market prices fluctuate. (7)

Speculating, on the other hand, is placing a bet that the market price will move one way or the other. (8) Like the generating corporation in the previous paragraph, a speculator who thought the price of coal would go up could purchase an option to sell at that higher price. Unlike the generating corporation, however, which is seeking to smooth things out, the speculator would probably choose to hedge less, if at all. The speculator is not seeking to break even on its investment but to turn a profit. Speculators, in this way, are trying to beat the market. (9) Both hedging and speculating involve a certain amount of risk, which is why some authors blame derivatives markets not only for the most recent financial crisis but for others as well, including the Enron collapse in 2001. (10)

After the 2008 financial crisis, people demanded that something be done about the use of these somewhat mysterious yet blameworthy financial products. (11) President Barack Obama urged Congress to pass legislation increasing regulation of financial markets. (12) Congress responded with the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), (13) which is the most comprehensive legislation concerning financial markets since the Great Depression. (14)

This Note examines one small aspect of the complex regulatory scheme that Congress set forth in the Dodd-Frank Act: its amendment to the Commodity Exchange Act (CEA). (15) Congress amended the CEA to include a definition of the term swap, which is one type of derivative. (16) In addition, Congress authorized the Commodity Futures Trading Commission (CFTC) to regulate certain swaps. (17) In its definition of the term swap, Congress expressly excluded certain types of contracts, including forwards. (18) This safe harbor matters for corporations that must comply with the new regulations.

This Note focuses on the term swap as it applies to corporations that use derivatives for hedging. …

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