Attorneys Suggest Changes to Proposed Regs on Hedging Transactions

Kramer and Pomierski also urge adoption of a rule of application that addresses commodities derivatives entered into by a dealer in commodities within preapproved position limits set out in its risk management program. With their letter, they include a model rule of application. The model rule, they say, recognizes the differences between dealers in commodities and their levels of risk tolerance, as well as the need for those dealers to demonstrate the viability of their risk management programs. Kramer and Pomierski further urge adoption of a general risk management standard consistent with congressional intent of allowing modern risk management transactions to qualify as "hedging transactions" under section 1221(a)(7).

[2] At the Hearing, your panel asked several questions about the proposed rule of application for "Dealers in Commodities" set out in the MWE Comments (the "Rule of Application"). ² Some of the questions from your panel focused on the process that a Dealer in Commodities goes through to adopt a "Risk Management Program." Another question dealt with whether IRS agents would be able to identify a legitimate Risk Management Program. These questions were reiterated by Viva Hammer, one of the members of your panel, during a follow-up telephone call with us on June 26, 2001. Given the importance of these questions, we want to respond more fully in this letter.

[3] In this letter, we first provide you with a brief summary of the proposed Rule of Application for Dealers in Commodities. Second, we include a description of the typical business activities of a Dealer in Commodities. Third, we address the process by which a Dealer in Commodities typically establishes and enforces a Risk Management Program that has been approved by its Board of Directors or senior management. Fourth, we address how the government can be assured of the legitimacy of a Risk Management Program for a Dealer in Commodities. And fifth, we provide our views on an appropriate risk management standard for general application to taxpayers.

I. BACKGROUND

[4] As set out more fully in the MWE Comments and in the description we set out below, a Dealer in Commodities routinely manages -- in the ordinary course of its business -- the risks of its core business operations by entering into transactions in physical commodities, over-the-counter commodity DERIVATIVES, and exchange- traded derivatives. For risk management purposes, a Dealer in Commodities is indifferent as to the type of commodity transactions it enters into, basing its trading decisions primarily on economic and liquidity factors prevailing at the time. Thus, a Dealer in Commodities views the various commodity products available for trading as fungible for risk management purposes.

[5] In the context of "hedging transactions" under Code §§ 1221(a)(7) and 1221(b)(2), the Rule of Application set out in the MWE Comments ³ is that non-dealer derivative ⁴ commodities transactions that meet three criteria should automatically qualify as "risk management" transactions. First, the transaction must be in a derivative, the value or settlement price of which is based on, or determined by reference to, the value of a commodity in which the Dealer in Commodities acts as a dealer. Second, the derivative transaction must have been entered into in accordance with formally adopted risk management policies established by the Board of Directors ("Board") or senior management of the Dealer in Commodities. And third, the transaction must not have been identified by the Dealer in Commodities as a transaction entered into in its derivatives dealer capacity. ⁵

[6] Our suggested Rule of Application for Dealers in Commodities is modeled on the treatment that the Treasury provides to aggregate hedgers under both the Current and Proposed Regulations under Code § 1221(a)(7). ⁶ It is assumed under the aggregate hedging regulations that all derivative transactions that are consistent with a taxpayer's aggregate hedging program meet the "risk reduction standard" under the Current Regulations. The Rule of Application assumes that all non-dealer commodities derivative transactions of a Dealer in Commodities that are consistent with its pre-approved Position Limits set out in a formally adopted Risk Management Program meet the new "risk management" standard under Code § 1221(a)(7). ⁷ In other words, under the Rule of Application, a Dealer in Commodities with a Risk Management Program formally adopted by its Board or senior management would be entitled to automatically treat all non-dealer commodities derivatives transactions entered into within its Position Limits as "hedging transactions" under Code §§ 1221(a)(7) and 1221(b)(2).

[7] The Rule of Application captures the essence of the risk management activities of Dealers in Commodities -- which is that all transactions entered into with its Position Limits are considered part of its core business activities. Like the aggregate hedging provision in the Current Regulations, the Rule of Application acknowledges that "risk management" is a concept that the Board or senior management of one taxpayer can view differently from the Board or senior management of another taxpayer. This is because the appropriateness of risk tolerances and risk management techniques vary from one dealer to the next. The Rule of Application allows each Dealer in Commodities to determine its own acceptable level of risk management for its core business operations in accordance with a formally adopted Risk Management Program.

II. DEALERS IN COMMODITIES

[8] The core business operations of a Dealer in Commodities is essentially as a merchant in physical commodities, a dealer in commodities derivatives, or both. These commodities may consist of energy-related products (such as electricity, natural gas, or coal), agricultural products (such as wheat or corn), or metals (such as aluminum or precious metals). A Dealer in Commodities regularly engages, in the ordinary course of its business, in buying (or producing) physical commodities from (or for), or selling physical commodities to, its customers. A Dealer in Commodities can stand ready to take positions on either side of a physical transaction at the right price. A Dealer in Commodities may also provide financial and risk management services to its customers by entering into commodities derivatives contracts with customers.

a. CUSTOMERS

[9] The customers of a Dealer in Commodities are typically customers that buy (or sell) physical commodities from (or to) the Dealer in Commodities in the dealer's capacity as a physical commodities dealer. Such customers may range from producers (such as electric utilities, natural gas producers, and farmers), to end users of a particular commodity, to other Dealers in Commodities. Often, the customers seek to obtain physical commodities and risk management products from the same dealer.

[10] As a result, a Dealer in Commodities often strives to provide a full range of services and products to its customers to remain competitive in its respective commodity markets. This means that a Dealer in Commodities attempts to understand and manage its customer's risks and to provide solutions to its customers' physical and/or derivative commodities needs. In this regard, a Dealer in Commodities, often on an ongoing and regular basis, keeps its customers informed about the latest products and developments in those commodities markets that are relevant to its customers.

b. RISK MANAGEMENT ACTIVITIES

[11] Regardless of whether it deals only in physical commodities, derivatives products, or both, the typical Dealer in Commodities essentially provides price risk management and liquidity to its customers, thereby allowing its customers to shift or transfer price risks to it. This risk shifting can result under an agreement to buy or sell a specified quantity of a particular commodity at a fixed price in the future, an option to buy or sell a commodity, or a commodities derivative contract (such as a swap) that provides a customer with price risk protection.

[12] A Dealer in Commodities may chose to hedge some -- or all -- of the risk that is created by the commodities transactions it enters into with its customers, by entering into offsetting physical commodities, over-the-counter derivatives, or exchange-traded derivatives transactions. As a result, a Dealer in Commodities generally earns a profit (or incurs a loss) by accepting the risk of price changes and then managing its price risks by entering into risk management transactions. Just like all other dealers, a Dealer in Commodities may profit (or lose money) from changes in commodity values during the interval between the purchase (sale) and the sale (purchase) of the commodities. In other words, a Dealer in Commodities accepts the risk of price changes, and then attempts to effectively manage its price risks by entering into risk management transactions.

[13] A Dealer in Commodities will often establish a detailed Risk Management Program that contains limits on risk exposure set by its Board or senior management to control (or prohibit) speculation. The Dealer in Commodities then authorizes its trading personnel to engage in approved physical and derivative commodities transactions -- within the pre-approved position limits set out in its Risk Management Program -- with the intent to make a profit from the difference between the price at which it sells (buys) and the price at which it buys (sells) commodities. As a result, a Risk Management Program essentially defines the core business activities of a Dealer in Commodities and the ways the dealer will manage those risks.

[14] The way in which a Risk Management Program is typically adopted is set out in the next section of this letter.

III. STRUCTURE OF RISK MANAGEMENT PROGRAMS

[15] At the Hearing, your panel asked how a Risk Management Program is actually established by a Dealer in Commodities. Prior to responding to these questions, we would like to say that we work with a large number of taxpayers that meet the definition of a Dealer in Commodities. Although each Dealer in Commodities determines its risk tolerances and its appropriate risk parameters in a different manner, in our experience, the common thread is that its Board or senior management adopts formal written policies that provide objective measures against which to monitor the dealer's business activities and to evaluate compliance with the formally adopted risk management policies. In the MWE Comments, we referred to these formally adopted risk management policies as a "Risk Management Program." ⁸

[16] In most cases, prior to authorizing any transactions (physical or derivative) that will affect its overall risk profile, a Dealer in Commodities' Board or senior management conducts an extensive analysis of its core business activities, its overall risk tolerances, and its hedging objectives. The Board or senior management first identifies the key objectives for its risk management policies. Often with the help of independent consultants, these business objectives are then reflected in the risk management policies ultimately approved by the Board or senior management. Typical business objectives addressed in a Risk Management Program include setting the company's overall direction with respect to the identification, measurement, monitoring, and control of the risks it faces from its core business activities as a dealer and from risk management transactions. In other words, the Risk Management Program approved by the Board or senior management is part of the standard control processes of a Dealer in Commodities. The Risk Management Program is an integral part of the dealer's core business activities.

[17] A Risk Management Program sets out the dealer's risk management policies and objectives. It sets out acceptable levels of risk exposure, based on the dealer's core business and financial strategies. To meet its obligations, the Board or senior management must understand the company's dealer and risk management activities, its derivatives usage, and the impact of approved transactions on its overall price risks. In fact, it is the Board or senior management that ensures that the company's risk monitoring and risk management operations have the necessary authority and resources to accomplish the company's objectives. It typically approves, in the Risk Management Program, authorized activities and strategies. It also designates those individuals (often by position, sometimes by name) that are authorized to enter into various types of transactions. Risk Management Programs typically provide for monitoring of all of dealer activities (physical, derivatives, or both) and risk management (hedging) activities. Although different Dealers in Commodities use different monitoring techniques, in our experience, a Dealer in Commodities typically establishes a formal committee, often referred to as the "Risk Management Committee" or "RMC," for the surveillance of all dealer and risk management (hedging) activities. In addition, a Dealer in Commodities frequently employs a risk manager (who is independent from its trading operations) to oversee its risk management activities on a day-to-day basis.

[18] The RMC, Board, or senior management evaluates the dealer's overall risk profile and its risk exposures in light of its core business activities. Trading risks, profits, and losses are reported (sometimes on a real-time basis but at least daily for an active dealer) to these managers who do not themselves conduct trading activities.

[19] When Position Limits are imposed on permitted activities, they clearly state whether the limitations apply to specified transactions, markets, activities, and individuals. A Risk Management Program typically establishes Position Limits with respect to the dealer's overall risk exposure for its core business activities, setting out the appropriate parameters within which the dealer will engage in its core business as a dealer and in its hedging activities. Position Limits can set out specific risk exposures or quantitative limits. Risk exposure guidelines are often measured on a value-at-risk basis (which quantifies the maximum probable loss in normal market and operating conditions) and with stress testing (which attempts to capture unexpected stresses to the markets and operations). Quantitative limits typically identify the maximum level of exposure, the maximum loss that can be incurred, and the amount of exposure that can be encountered in times of unusual market or financial conditions.

[20] A Risk Management Program typically establishes internal controls that are in line with the scope, size, and complexity of the dealer's authorized activities, as well as the nature and extent of its tolerance for its core business activities and attendant risks. Internal controls, for example, generally assure that there is an adequate separation of functions and duties, with a complete separation between the company's trading operations (dealer and hedging activities) and its risk management oversight.

[21] Trading employees and support personnel for dealer and hedging activities are typically required, as part of a Risk Management Program, to be properly trained, with an appropriate level of trading expertise for the level of their responsibilities. They must have a solid understanding of the dealer's specific risk exposures and hedging strategies with respect to its core business activities. In our experience, a Dealer in Commodities conducts (or provides access to) selected training programs to assure that its traders understand the nature of the dealer's relevant markets, their responsibilities to the dealer, and the dealer's risk management guidelines and controls (as embodied in the Risk Management Program).

[22] The provisions of Risk Management Programs are strictly enforced. Individual "traders" are generally required to sign an acknowledgement stating that they have read and understand the Risk Management Program, including the limitations placed on various trading activities. All traders are then required to document, record, and report all of their physical and derivatives dealer transactions and hedging activities. Traders are required to clearly understand authorized transactions, prohibited activities, portfolio limits, and all individual trading limits. In practice, a trader's continued employment depends on his or her compliance with the Risk Management Program and applicable Position Limits. Violations -- which can be identified on a daily basis, if not sooner, -- are immediately reported to the RMC, the Board, or senior management. Any trader who violates portfolio limits, his or her own position limits, or enters into unauthorized or prohibited activities is subject to disciplinary action that may include immediate termination of employment.

IV. HOW THE GOVERNMENT IS ASSURED OF LEGITIMATE RISK MANAGEMENT

[24] A Risk Management Program sets out Position Limits that are based on -- and grow out of the Dealer in Commodities need to maintain -- acceptable price risks with respect to its core business in the first place. Position Limits are carefully determined, by the Board or senior management, based on its overall assessment of the dealer's business objectives and risk tolerances. Pre-approved position limits reflect the dealer's business strategies and risk tolerances.

[25] Once Position Limits are established, those individuals who are authorized to engage in physical or derivatives positions (or both) can enter into transactions within the pre-approved Position Limits without seeking any further management approval. As a result, Position Limits establish the "outer limits" of price risk exposure that the Board or senior management of a Dealer in Commodities is willing to accept from its core business activities. In other words, they set out the maximum price risk that a dealer is willing to be exposed to in its business. These considerations are fundamental to the dealer's core business. They are not tax driven.

[26] Take for example Taxpayer N, a dealer in natural gas and natural gas derivatives. Assume N's risk management program establishes position limits of net long 100xx units of natural gas, and net short of 100xx units of natural gas on a portfolio basis. This means that, in the aggregate, N's Position Limits provide that N must not hold or enter into positions that result in price risk beyond 100xx units -- whether actual or notional -- net long or net short.

[27] Assume that, after taking into account all offsetting physical and derivative natural gas positions, N is net long exactly 100xx units. At that point, N would not be authorized to enter into any additional positions that would increase its net long position, regardless of the type or nature of the transaction, without prior approval of N's Board or senior management. If a long transaction were contemplated that would -- by itself -- exceed N's position limits, that position would have to be offset (balanced) against a short position that would have the net effect of preventing N's exposure from becoming further long. For example, if it were assumed that N was already net long 100xx units of natural gas, N would not be allowed to enter into a long fixed price forward sale agreement with a customer on a stand-alone basis. N would, however, be allowed to enter into a position that takes it beyond its pre-approved position limits, such as by agreeing to sell 20xx units of natural gas to a customer at a fixed price in the future, if such long position was immediately offset by (balanced against) a short position allowing N to buy 20xx units of natural gas also at a fixed price (or was offset by a short derivative position providing N with equivalent price risk protection).

B. Formal Risk Management Programs Provide Adequate Protections to the Government.

[28] Under the Current and Proposed Regulations, an aggregate hedger does not need to demonstrate that each transaction that it enters into "manages" its overall risk, if the transaction was entered into pursuant to an aggregate hedging program that meets the requirements set out in the Current and Proposed Regulations, including a description of the aggregate risks being hedged and the hedging program under which the transaction is entered into. Likewise, to the extent that the Board or senior management of a Dealer in Commodities adopts a formal Risk Management Program that establishes pre-approved Position Limits, such a dealer should not be required to demonstrate that each non-dealer commodities derivative contract entered into within its Position Limits "manages" its overall risk.

[29] Treas. Reg. § 1.1221-2(e)(3)(iv) provides that an aggregate hedging program must include: (1) identification of the type of risk being hedged; (2) a description of the types of items giving rise to the risks being aggregated; (3) sufficient additional information to demonstrate that the program is designed to reduce aggregate risk of the type identified; and (4) if it contains controls on speculation (for example, position limits) the description of the hedging program must explain how the controls are established, communicated, implemented, and enforced.

[30] A formally adopted Risk Management Program of a Dealer in Commodities should qualify as a "program" of the sort eligible to cover risk management transactions if it includes controls similar to those established under the Current and Proposed Regulations for aggregate hedging programs. These controls should include (1) an identification of the types of risks being managed by the taxpayer; (2) a description of the types of items giving rise to the risks being managed; (3) sufficient additional information to demonstrate that the risk management program is designed to control or maintain risk of the type identified in accordance with the risk parameters set out in a formal risk management policy statement approved by the taxpayer's senior management; and (4) controls on speculation (for example, position limits), with an explanation as to how these controls are established, communicated, implemented, and enforced.

V. RISK MANAGEMENT IN GENERAL

[31] In a follow-up call on June 26th with Viva Hammer, we were asked to provide in this letter our views with respect to the manner in which "risk management" may be defined by the Treasury Regulations for general application to all taxpayers, not just for Dealers in Commodities. In this section of the letter we set out our view that the Rule of Application for Dealers in Commodities described in this letter, the MWE Comments, and the Kramer Testimony, could be extended into a general rule of application for all taxpayers.

[32] As we have stated, Congress clearly intended for modern risk management transactions to qualify as hedging transactions under Code § 1221(a)(7). This means that the Treasury regulations issued under Code § 1221(a)(7) must establish "risk management" (and not risk reduction) as the operative standard for hedging transactions. We believe that the concept of "risk management" does not lend itself to an objective standard that can be applied to all taxpayers in all circumstances. By definition, the concept of risk management has a subjective element that is -- and must be -- unique to each taxpayer.

[33] We believe that our proposed Rule of Application could be modified to become a general rule of application for all taxpayers. In essence, this would mean that a taxpayer would need to define its core business activities and the scope of its own risk management activities. The taxpayer would need to formally adopt a Risk Management Program that sets out, in precise detail, the derivative transactions that are permitted to be entered into within its pre- approved Position Limits. Under this general rule, any derivative transaction that alters a taxpayer's risks associated with the ordinary course of its core business activities would qualify as a hedging transaction if the derivatives transaction relates to the taxpayer's core business activities. The hedging transaction would need to relate to the taxpayer's core business activities in order to fall within the scope of such a general rule of application for all taxpayers.

[34] In order to determine whether a derivatives transaction relates to the taxpayer's core business activities, a taxpayer with a formally adopted Risk Management Program that includes pre-approved Position Limits would, as in the case of a Dealer in Commodities, be able to automatically treat any non-dealer derivatives transactions entered into within its pre-approved Position Limits as a risk management activity. A sample Rule of Application for taxpayers in general is attached as Exhibit II.

[35] Any transactions that are entered into that fall outside of any such pre-approved Position Limits would then qualify as a tax hedging transaction -- or not -- depending on whether the taxpayer can show that the risks associated with its core business activities have been managed or altered in the ordinary course of its trade or business. For any taxpayer that does not adopt a formal Risk Management Program with pre-approved Position Limits, the definition of a qualifying risk management transaction would then be determined based on whether the derivative transaction managed or altered the taxpayer's risks as part of the ordinary course of its trade or business. In other words, we would espouse a view that risk management activities could be defined as any transaction that alters or manages a taxpayer's risks provided that the transaction is entered into as part of the taxpayer's ordinary course of business.

VI. CONCLUSIONS

[36] We urge the Treasury to revise the Proposed Regulations to replace the concept of "risk reduction" with the Congressionally mandated standard of "risk management." In providing examples of modern risk management activities that qualify as "hedging transactions" under Code § 1221(a)(7), we urge that the final regulations include the Rule of Application we set out as Exhibit I to address commodities derivatives entered into by a Dealer in Commodities within pre-approved Position Limits set out in its formally adopted Risk Management Program.

[37] This Rule of Application closely follows the approach taken by the Treasury for aggregate hedgers in the Current Regulations. This Rule of Application recognizes the existence of appropriate and inevitable differences between each Dealer in Commodities as to its risk tolerances and risk management techniques. It also recognizes that a Dealer in Commodities must be able to demonstrate that its Risk Management Program is reasonably expected to assure that the overall risks of its core business operations are consistent with the standards established in its Risk Management Program. The Dealer in Commodities must also be able to demonstrate that its Risk Management Program is designed to measure and monitor risk of the type identified in accordance with the risk parameters set out in the program, including Position Limits, and a discussion of the way in which such controls are established, communicated, implemented, and enforced. We urge adoption of the Rule of Application for Dealers in Commodities in the form we have set out in Exhibit I to this letter.

[38] We also urge Treasury to adopt a general risk management standard that will be consistent with Congressional intent of allowing modern risk management transactions to qualify as "hedging transactions" within the meaning of Code § 1221(a)(7). To meet its congressionally mandated objectives, we believe that the Treasury could modify the Rule of Application we propose for Dealers in Commodities to become a general rule of application. If the Rule of Application were modified to apply to all taxpayers (and not just Dealers in Commodities), the Treasury could provide that any derivative transaction that alters a taxpayer's price risks associated with the ordinary course of the taxpayer's business would automatically qualify as a risk management transaction if it related to the taxpayer's core business activities and is entered into pursuant to a formal Risk Management Program.

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[39] We would be pleased to discuss our proposal with you further. And, you can contact either one of us at the phone number or email address that we provide below.

Sincerely,

² Dealers in Commodities, for these purposes, are persons that act as dealers in either or both physical commodities and commodities derivative financial instruments. It does not include "commodities dealers" under Code § 1402(i)(2)(B). Dealers in Commodities would include, for example, dealers in energy products, agricultural products, and metals. These dealers provide valuable liquidity to both the physical and derivatives markets by holding themselves out as continuously willing to buy or sell commodity products, or to enter into commodity derivatives.

³ Attached as Exhibit I is a copy of the proposed Rule of Application, which is taken from Appendix A of the MWE Comments, cleaned up to reflect a few minor changes.

⁴ By limiting the Rule of Application to derivative commodities transactions, physical commodities transactions would be included in the items being hedged, rather than being treated as hedging or risk management transactions.

⁵ Derivative transactions entered into in a "dealer" capacity would be included in the items being hedged, rather than being treated as hedging or risk management transactions.

⁶ Capitalized words and phrases that are not defined in this letter are defined in the MWE Comments.

⁷ The Rule of Application provides that a "Risk Management Program" must include an identification of the types of risks being managed, a description of the items giving rise to the risks being managed, and sufficient additional information to demonstrate that the Risk Management Program is designed to measure and monitor risk of the type identified in accordance with the risk parameters set out in a formal policy statement approved by the taxpayer's Board or senior management.

⁸ For your convenience, we have attached as Exhibit III an outline prepared by Andrea S. Kramer entitled "Items to Consider for Trading and Derivatives Policies, Guidelines, Controls, and Internal Procedures." This outline provides an in-depth discussion of the considerations that are typically involved in structuring and implementing a risk management program.

EXHIBIT I

TREAS. REG. § 1.1221-2(c)(1)(viii)

RULE OF APPLICATION FOR A DEALER IN COMMODITIES

(viii) TRANSACTIONS THAT MANAGE RISK. -- (A) IN GENERAL. A risk management transaction entered into by a dealer in commodities other than in its dealer capacity generally will be respected as managing risk if it is undertaken as part of a risk management program that, as a whole, is reasonably expected to assure that the overall risks of the taxpayer's operations are consistent with the standards established in its risk management program. The taxpayer generally does not have to demonstrate that each hedge that was entered into pursuant to its risk management program manages its overall risk.

(B) DEFINITIONS. For purposes of § 1.1221-2(c)(1)(viii)(a), a risk management program must include an identification of the types of risks being managed; a description of the type of items giving rise to the risks being managed; and sufficient additional information to demonstrate that the risk management program is designed to measure and monitor risk of the type identified in accordance with the risk parameters set out in a formal policy statement approved by the taxpayer's senior management. Such a program must contain controls on speculation (for example, position limits) and must explain how such controls are established, communicated, implemented, and enforced.

A dealer in commodities includes a dealer in physical commodities, a commodities derivatives dealer (as defined in Code § 1221(b)(1)(A)), or a dealer in both physicals and derivatives. A dealer in commodities does not include a "commodities dealer" as defined in Code § 1402(i)(2)(B).

A risk management transaction means any transaction in a commodities derivative (whether exchange-traded or over-the-counter) that is entered into by a dealer in commodities in the normal course of its commodities dealer business if (i) the value or settlement price of the transaction is based on or determined by reference to the value of a commodity in which the dealer in commodities is a dealer; (ii) the transaction is entered into within the position limits set out in its risk management program; and (iii) the transaction is not identified by the dealer in commodities as a transaction entered into in its dealer capacity.

Position limits are pre-approved controls on speculation that are set out in the risk management program.

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EXHIBIT II

TREAS. REG. § 1.1221-2(c)(1)(viii)

RULE OF APPLICATION FOR TAXPAYERS WITH RISK MANAGEMENT PROGRAMS

(viii) TRANSACTIONS THAT MANAGE RISK. -- (A) IN GENERAL. A risk management transaction entered into by a taxpayer other than in its dealer capacity generally will be respected as managing risk if it is undertaken as part of a risk management program that, as a whole, is reasonably expected to assure that the overall risks of the taxpayer's operations are consistent with the standards established in its risk management program. The taxpayer generally does not have to demonstrate that each hedge that was entered into pursuant to its risk management program manages its overall risk.

(B) DEFINITIONS. For purposes of § 1.1221-2(c)(1)(viii)(a), a risk management program must include an identification of the types of risks being managed; a description of the type of items giving rise to the risks being managed; and sufficient additional information to demonstrate that the risk management program is designed to measure and monitor risk of the type identified in accordance with the risk parameters set out in a formal policy statement approved by the taxpayer's senior management. Such a program must contain controls on speculation (for example, position limits) and must explain how such controls are established, communicated, implemented, and enforced.

A risk management transaction means any derivative transaction (whether exchange-traded or over-the-counter) that is entered into by a taxpayer in the normal course of its trade or business if (i) the transaction is entered into within the position limits set out in its risk management program; and (ii) the transaction is not identified by the taxpayer as a transaction entered into in its dealer capacity.

Position limits are pre-approved controls on speculation that are set out in the risk management program.

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EXHIBIT III

ITEMS TO CONSIDER FOR TRADING AND DERIVATIVES POLICIES, GUIDELINES, CONTROLS, AND INTERNAL PROCEDURES

ITEMS TO CONSIDER FOR TRADING AND DERIVATIVES POLICIES, GUIDELINES, CONTROLS, AND INTERNAL PROCEDURES

TABLE OF CONTENTS

I. RISK MANAGEMENT POLICY