Proving Intent to Manipulate Markets

Deck: 

Should FERC look to all Securities and Exchange Commission precedent for a model?

Fortnightly Magazine - May 2006

New regulations from the Federal Energy Regulatory Commission (FERC) to prevent energy industry market manipulation take deep root in securities industry law. Modeled in part on the Securities Exchange Act of 1934 (Exchange Act), the Energy Policy Act of 2005 (EPACT) outlaws direct or indirect use or employment of manipulative or deceptive devices or contrivances in energy industries FERC regulates under the Natural Gas Act (NGA), the Natural Gas Policy Act of 1978 (NGPA), and the Federal Power Act (FPA).

That statutory mouthful boils down to a prohibition against manipulation and fraud in U.S. wholesale markets for natural gas and electric energy. EPACT does not prohibit merely negligent practices or corporate mismanagement in those markets.

Order 670

FERC’s January 2006 Order 670 final rule prohibits market manipulation and fraud in those parts of the U.S. gas and electric industries subject to FERC jurisdiction under the NGA, the NGPA, and the FPA.1 Effective Jan. 26, 2006, FERC’s general regulations §§1c.1 and 1c.2 prohibit any entity, including governmental utilities and other market participants, from directly or indirectly: (i) using or employing any device, scheme, or artifice to defraud; (ii) making any untrue statement of a material fact, or omitting a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading; or (iii) engaging in any act, practice, or course of business that operates or would operate as a fraud or deceit on any entity.2

Showing intent, or “scienter,” to commit those acts is critical to avoid insufficient, vague, or conclusory allegations, enabling effective, predictable FERC enforcement of the new anti-market manipulation laws. FERC’s Order 670 regulations do not reach every common law fraud, but only those frauds intended to affect, or where an entity intentionally acted recklessly to affect, a FERC-jurisdictional transaction.3 No scienter, no violation.4

The Private Securities Litigation Reform Act of 1995

FERC declares that the substantial, significant body of legal precedent applying Exchange Act § 10(b) and Securities and Exchange Commission (SEC) Rule 10b-5 will benefit energy industry entities subject to Order 670.5 Given the securities law model for EPACT, FERC will apply securities regulation precedents to the energy markets to prevent manipulation and fraud, including securities precedent on the element of the scienter or intent of alleged manipulators.

However, the degree to which FERC will rely on securities law for the meaning of scienter is not plain. For example, neither EPACT nor Order 670 discuss the Private Securities Litigation Reform Act of 1995 (PSLRA), which imposes a heightened pleading requirement on securities exchange private actions, forcing plaintiffs to state the facts giving rise to a “strong inference” that the defendant acted with the required state of mind.6 That PSLRA standard applies in securities law private actions, as shown in recent case law treated below. EPACT tracks the Exchange Act, and Order 670 regulations are patterned after SEC Rule 10b-5.7 Order 670 insists the scienter element will apply just as it applies to SEC Rule 10b-5.8 Therefore, precedents on the PSLRA strong-inference-of-scienter standard appear to be available without difficulty for use in identifying and preventing energy market manipulations and frauds.

On the other hand, FERC conceivably could reject the PSLRA strong inference standard as appropriate only for securities law actions brought to court by private individuals, perhaps finding the PSLRA scienter standard either inapplicable or applicable only to a lesser degree for purposes of FERC’s own administrative enforcement actions. Determining it illogical to ignore decades of useful guidance that securities precedents offer, Order 670 nevertheless recognizes that the FERC mission to protect purchasers from unjust and unreasonable rates and services differs from the SEC mission to assure a regime of disclosure for security purchases.9 Both EPACT and Order 670 avoid creating private rights of action, leaving FERC administrative action as the only procedural avenue against energy market manipulation.10 Private litigation is common under the securities laws, but an Order 670 footnote says that while such cases “may be instructive on certain points, the elements needed for a private right of action are not the same as those required” for FERC administrative enforcement action.11

FERC Requirements

In Ernst & Ernst v. Hochfelder, the U.S. Supreme Court held that a private lawsuit for damages under §10(b) and Rule 10b-5 requires allegation of scienter.12 Also, the words “manipulative,” “device,” and “contrivance” make unmistakable congressional proscription of a type of conduct quite different from negligence.13 Finally, scienter must be established as an element of the SEC’s own civil enforcement actions to enjoin violations of §10 (b) and Rule 10b-5. Aaron v. SEC, 446 U.S. 680, 682-84, 701-02 (1980). Order 670 echoes those rulings by declaring that any energy industry market manipulation violation requires a showing of scienter, relying on appellate court rulings to conclude that recklessness satisfies the scienter element as well.

Copious PSLRA Precedent

Securities case law evaluating private rights of action under the PSLRA strong-inference-of-scienter test distinguishes intentional or reckless scienter from merely negligent practices or corporate mismanagement. But what is such scienter? How can it be recognized? As one federal judge observes, concrete guidance on what constitutes recklessness can be gleaned by looking to the facts in those cases in which pleadings have been analyzed.14 Whether the scienter allegations fail or succeed, such securities case law can instruct FERC enforcement analysis, as follows.

• Motive and opportunity, or recklessness, must be shown. Securities precedents where scienter is not alleged cogently can transfer readily to the energy industries. For corporate executive scienter, a person’s job description is not enough. Facts must link the executive with culpable behavior, or scienter is not shown. The scienter starting point is to require factual indication of motive, such as concrete benefits to the defendants, and of opportunity, or means and prospect of achieving those benefits. In re Dynex Capital, No. 05 Civ. 1897, 2006 U.S. Dist. LEXIS 4988 at *6-7, 25-29 (S.D.N.Y. Feb. 10, 2006). Alternatively, recklessness suffices if knowledge of facts or access to information contradicting defendants’ corporate public statements is alleged. Mere position in a corporate hierarchy does not show intent.15 Regarding a financial services corporation’s bundling of loans as assets backing bonds, there was no scienter in pointing to mere involvement in loan approvals violating internal underwriting guidelines. No access to specific reports or statements about malfeasance or supervision of wrongdoers was alleged.

• Mistakes from negligence alone are not punishable. Analogies to the energy industries are found in securities cases on the lack of scienter in standard business conduct. Where a scheme was claimed to inflate a stock price with a press release about government approval of a prescription product, the court noted the purpose to punish knowing fraud or reckless behavior, but not mistakes from negligent or even grossly negligent behavior.16 There was no scienter in an alleged effort to reduce cash outlays for debt service because that generalized motive to reduce costs is common to most, if not all, corporations. Nor was it reckless to omit from the press release more detailed data, for which there was no obvious duty to disclose.

Details, details, details. A chief instruction from recent securities case law is the judicial focus on sufficient scienter detail. While FERC enjoys substantial discretion, it is not unlikely that future judicial review will focus on whether energy industry enforcement scienter has been detailed adequately. A recent case17 showed no specific details of discrimination by a broker-dealer options specialist and its clearinghouse against a customer’s purchase and sell orders. Another case showed no telecommunications company scienter absent details on how overhead costs were allocated or on any improper allocation practices.18 Scienter again was insufficient about insider trading after a stock price rise, absent explanations of the percentage of stock sold and what the figures represented, and details of personal involvement for corporate officials’ scienter of obvious financial, cash flow, and accounting problems.19 There likewise was no scienter for a financial service company parent corporation or its president without documents or other details showing intentional disregard of mobile home loan underwriting guidelines.20

Motive to profit at investor expense and reckless disregard of non-creditworthiness suffice. Just as in securities industry cases where scienter is alleged effectively, the more plain the motive and opportunity, or the recklessness, the more plausible the showing. Scienter was pleaded based on the officers’ and employees’ motive and opportunity to make short-term profits at investor expense in Dynex.21 Allegations of systematic disregard for borrowers’ lack of creditworthiness in order to complete large volumes of loans quickly, ignoring signs of defective bond collateral, showed recklessness.

Aberrant business conduct showing scienter. In energy industries, as well as the securities industry, if the act speaks volumes, such as failure to explain the ongoing risks of poor corporate finances, scienter showings are facilitated. Scienter was pleaded in parent corporation lack of public disclosure of the execution of loan guarantee financing arrangements for a cruise line customer’s purchase of eight cruise ships.22 Recklessness claims were bolstered by allegations the corporation knew of the cruise line customer’s precarious financial condition and failed to reveal that risk, while extending the customer hundreds of millions of euros of loan guarantees and continuing to tout high ship sales levels publicly. Corporate officers had scienter in allegedly signing SEC filings containing misrepresentations, while failing to learn that loan guarantees constituted a disproportionately high amount of overall debt and had not been disclosed. Also, a subsidiary allegedly had scienter in excluding millions of dollars of railcar contract costs from its financial statements.

Scienter is established by linking corporate behavior to culpable individuals. For energy market manipulations as well as securities violations, scienter is shown in connecting the defendant to the culpability. Financial services company assurances of underwriting standards integrity were alleged to be false because, as the entity servicing the collateral, the company was responsible for reviewing delinquencies and knew, or should have known, of underwriting violations.23 Senior management had scienter in allegedly directing employees to generate uncreditworthy loans and underreport delinquencies, violating underwriting guidelines day-to-day. Scienter was alleged given an affiliate’s functions to issue certificates supposedly secured by mobile home installment sales contracts and mortgage loans that were of low quality, and to file SEC reports on such collateral. Director officers with access to fraudulent underwriting data allegedly had scienter.

Specifics, specifics, specifics. Both securities-industry scienter and energy-industry scienter are fact-based. There was scienter when an attorney allegedly knew of fabricated investment performance and other facts omitted from a securities investment brochure provided to investors for an offshore investment scheme, and the attorney’s law firm allegedly took actions, including SEC regulatory tactics, to conceal its role.24 Claims that a telecommunications company overstated its line counts of new customers were sufficiently particular as to scienter to inflate its publicly reported statistics.25 Scienter was pleaded for corporate officials’ personal direction of a fraudulent accounting entry of a $1.2 million sale while knowing the purchase already had been canceled.26 An official who signed an SEC form, knowing it to be based incorrectly on the $1.2 million sale entry, allegedly had scienter.

PSLRA Precedents Should Benefit FERC Enforcement

Wholesale gas and electric markets are susceptible to manipulation and fraud. Analogous securities regulation precedents are to be adapted to specific energy industry facts, circumstances, and situations to help identify and prevent those illegalities. Order 670 addresses energy market manipulations in part by adopting the scienter element for violations under SEC regulation.27 As shown above, PSLRA scienter precedents should benefit energy industry FERC enforcement.

FERC should apply the entire body of securities case law, including cases under the PSLRA strong-inference-of-scienter standard, to energy market manipulations. In that way, insufficient, vague, or conclusory allegations will be discouraged, and predictable enforcement policy will be benefited. Failure to consider the PSLRA strong-inference-of-scienter standard case law would segregate those precedents from use for FERC enforcement purposes, complicate interpretation of the Order 670 regulations, and add unpredictability to energy industry compliance efforts.

 

Endnotes:

1. Prohibition of Energy Market Manipulation, Order No. 670, 114 FERC ¶ 61,047; FERC Stat. & Reg. ¶ 31,202; 71 Fed. Reg. 4244-58 (Jan. 26, 2006), reh’g denied, 114 FERC §61, 300 (2006). The Final Rule does not reach oil pipeline transportation industry manipulation and fraud. Order 670, Para. (“P”) 24.

2. 18 C.F.R. §§ 1c.1 & 1c.2.

3. Order 670, PP 16, 20, 22 & n.39, 25.

4. Id., PP 45, 52.

5. Id., P 7.

6. 15 U.S.C. § 78u-4(b)(2).

7. Order 670, PP 2, 6, 30.

8. Id., P 31 n.56.

9. Id., PP 32, 48-49.

10. Id., PP 2, 17 & n.30. Issues of prosecutorial discretion certainly can arise, and should be informed by FERC Office of Market Oversight and Investigations access to appropriate technical expertise. See 114 FERC §61, 300, supra, P 9.

11. Id., P 48 n.100.

12. 425 U.S. 185, 193, 201 (1976).

13. Id., at 199. In Ernst & Ernst, the cause of action rested only on a theory of negligent nonfeasance, under which an accounting firm assertedly failed to conduct proper audits of a brokerage firm whose president perpetrated a securities fraud for many years. The complainants specifically disclaimed fraud or intentional conduct by the accountants. Id., at 188-90.

14. In re Alstom S.A., No. 03 Civ. 6595, 2005 U.S. Dist. LEXIS 35641 at *17 (S.D.N.Y. Dec. 22. 2005).

15. Accord Alaska Electrical Pension Fund v. Adecco, S.A., et al., 371 F. Supp.2d 1203, 1216-19, 1221-23 (S.D. Cal. 2005).

16. In re Geopharma, No. 04 Civ. 9463, 2006 U.S. Dist. LEXIS 3342 at *3 & n.4, 17, 25-28, 31-41 (S.D.N.Y. Jan. 27, 2006).

17. Gurfein v. Ameritrade, et al., No. 04 Civ. 9526, 2006 U.S. Dist. LEXIS 3128 at *24-27 (S.D.N.Y. Jan. 26, 2006).

18. In re Adelphia Communications Corp., 398 F.Supp.2d 244, 253-55 (S.D.N.Y. 2005).

19. Wojtunik v. Kealy, 394 F.Supp.2d 1149, 1165-69 (D. Ariz. 2005).

20. Teamsters Local 445 Freight Div. Pension Fund v. Bombardier, No. 05 Civ. 1898, 2005 U.S. Dist. LEXIS 19506 at *68-74 (S.D.N.Y. Sep. 6, 2005).

21. Dynex, supra, at *29-32.

22. Alstom, supra, at *45-46, 48-56, 59-62, 82-83.

23. Teamsters Local 445, supra, at *59-63, 65-66.

24. Cliff v. Hyman Lippitt, No. 05-72221, 2005 U.S. Dist. LEXIS 38144 at *10, 21-22, 27-29 (E.D. Mich. Dec. 29, 2005).

25. Adelphia, supra, 398 F.Supp.2d at 249-52.

26. Wojtunik, supra, 394 F.Supp.2d at 1167-69.

27. Order 670, PP 32, 49-53.