Electric utility compliance programs typically cover regulatory requirements imposed by the Federal Energy Regulatory Commission (“FERC”) under the Federal Power Act or Natural Gas Act and, more recently, by the Commodity Futures Trading Commission (“CFTC”) under the Dodd-Frank Act. Regulations issued by those two commissions are monitored closely. But, if your electric utility does not monitor the actions of other federal agencies impacting energy trading and put related controls in place, your electric utility is at risk — as evidenced dramatically by a new rule proposed by the Federal Reserve Board of Governors.
The proposed rule restricts an electric utility’s ability to exercise default rights in not only futures and swap contracts, but also forward contracts. Many electric utilities may not be aware that this proposed rule impacts them because it uses the phrase Qualified Financial Contracts (“QFCs”) to describe the type of contracts subject to the rule. At first blush, such phrase ordinarily would not be thought to include a forward contract. But, it does.
The proposed rule emanates primarily from the “orderly liquidation” authority in the Dodd-Frank Act. That Act establishes a special resolution process for failed financial firms, which are important to the financial system and economy. As part of the special resolution process, the rights of a failed financial firm’s counterparties to terminate their contracts can be stayed, with the aim of allowing a transfer of the QFC obligations to another party with resources to continue to perform the obligations.
The proposed rule does two main things: (1) requires a covered entity to ensure that QFCs to which it is a party provide that any default rights and restrictions on the transfer of the QFCs are limited to the same extent as they would be under the Dodd-Frank Act; and (2) prohibits a covered entity from being a party to QFCs that would allow a QFC counterparty to exercise default rights against the covered entity based on the entry of an affiliate of the covered entity into a resolution proceeding (including not only a special resolution proceeding but also a bankruptcy proceeding).
The “covered entities” obligated to comply with the proposed rule include global systemically important banking organizations (“GSIBs”) and their subsidiaries. This includes, for example, subsidiaries of Morgan Stanley and Citigroup, which may trade with electric utilities in energy markets.
Moreover, the definition of “default right” captures contract provisions common in the energy industry. Subject to some exceptions, a default right generally is defined as a right to:
- liquidate, terminate, cancel, rescind, or accelerate an agreement or transactions thereunder;
- set off or net amounts owing in respect thereto;
- exercise remedies in respect of collateral or other credit support or property related thereto;
- demand payment or delivery thereunder or in respect thereof;
- suspend, delay, or defer payment or performance thereunder, or modify the obligations of a party thereunder;
- alter the amount of collateral or margin that must be provided with respect to an exposure thereunder;
- demand the return of any collateral or margin transferred by it to the other party or a custodian or to modify a transferee’s right to reuse collateral or margin; or
- any similar rights.
Comments are due on the proposed rule by August 5th and the rule has not yet taken effect. But, electric utilities need to begin planning now to mitigate the risks of this rule, including by, among other things, taking a fresh look at which counterparties they will and will not trade with as a result of the rule.
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