Market Manipulation: The Business Questions

Few areas of the power industry regulation have received as much attention over the last decade as the enforcement authority exercised by the U.S. Federal Energy Regulatory Commission. FERC has invested significantly in its enforcement capabilities, sometimes reaching outside the electric utility industry to recruit career prosecutors to participate in (if not head) the commission's investigative program. The media has widely reported on some of the more high-profile cases, with some settlement or disputed amounts soaring into the hundreds of millions of dollars. However, beyond FERC's organic orders and policy statements, there are few if any cases interpreting the commission's authority over market manipulation.

Most FERC investigations settle. The few cases that are litigated tend often to be very fact-specific - complex and often confusing, to many. Consequently, many market participants struggle to evaluate the risks of participating in energy markets.

A common frustration arises in trying to evaluate the business risk involved in defending against an alleged claim of market manipulation. Federal regulators, it appears have purposely avoided providing any detailed guidance to define specific prohibited behavior or to stake out a "safe harbor." Instead, the industry is left to follow guidance akin to the old adage, "you know it when you see it." Without a clear definition of market manipulation, or a detailed description for prohibited conduct, market participants are often left with more questions than answers. That presents difficulties at the management level. Companies want to be able to evaluate the business risks that underlie their activities - both in designing programs for internal compliance, and in training their employees.

To offer some help, we've listed the questions we are most often asked by management-level personnel, along with some answers that we trust will help shed some light on this shadowy facet of FERC regulation.

1. What is Market Manipulation?

The term "manipulation" traditionally has been used "imprecisely and indiscriminately" by federal courts and regulators. For instance, the U.S. Supreme Court has explained that market manipulation "refers generally to practices, such as wash sales, matched orders, or rigged prices, that are intended to mislead investors by artificially affecting market activity." Consistent with the High Court's reluctance to provide more specific guidance, FERC has declined to clearly define the conduct that constitutes market manipulation. Instead, it has interpreted market manipulation broadly to cover "any action, transaction or conspiracy for the purpose of impairing, obstructing or defeating a well-functioning market."

FERC's Anti-Manipulation Rule, 18 C.F.R. § 1c, speaks only in general terms. The Rule makes it unlawful for any entity, directly or indirectly, in connection with the purchase or sale of electric energy or natural gas or the purchase or sale of transmission or transportation services subject to FERC jurisdiction, to do any of the following:

• Use or employ any device, scheme, or artifice to defraud;
• Make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading; or
• Engage in any act, practice, or course of business that operates or would operate as a fraud or deceit upon any entity.

The FERC rule is based on the Securities and Exchange Commission's Rule 10b-5 and interpretative case law. A violation of SEC Rule 10b-5 requires that a prosecutor prove not only intent, but also an actual falsehood, deception or fraud. Sometimes a prosecutor may push to reduce the case to mere proof of intent, but that is not sufficient. The Supreme Court has explained that "Section 10(b) is aptly described as a catchall provision, but what it catches must be fraud." This requirement applies also for FERC investigations.

2. Can "open market" transactions be considered manipulative?

Yes. At least in FERC's opinion, a potentially manipulative transaction may be perpetrated through "open market" transactions - i.e., transactions implemented on public trading platforms based, at least in part, on the rates, terms, and conditions of FERC-approved tariffs or rules. FERC has been very clear to explain that there is no safe harbor to a market manipulation claim based on a theory that a transaction (or a series of transactions) was implemented pursuant to FERC-approved tariffs or market rules.

In practice, this means that FERC may not be persuaded by an attempted defense that a defendant complied with the "letter" of the relevant tariff or simply took advantage of a tariff "loop hole" when engaging in a potentially manipulative transaction.

For example, in July 2013, FERC assessed a $435 million penalty against Barclays Bank PLC ("Barclays"), and certain Barclays traders, based on a market manipulation theory for transactions implemented between 2006 and 2008. FERC alleged Barclays intentionally suffered losses in the electricity markets subject to the regional FERC-jurisdictional tariffs to improve its position on financial instruments traded on the Intercontinental Exchange (ICE). In its defense, Barclays argued that open market transactions such as those implemented through independent system operator tariffs on ICE cannot be manipulative because they were conducted transparently. This case is now at the federal district court in the Eastern District of California, which has rejected Barclays' position, reasoning that legitimate trades with an illegitimate purpose can constitute manipulation and stating:
"[n]o doubt, Congress meant to prohibit the full range of ingenious devices that might be used to manipulate securities prices."

In the context of market manipulation, many regulators have taken the position that tariffs and rules reflect a "code of ethics" as much as they may reflect market rules. Thus, although compliance with a tariff or market rule is clearly relevant, it may not be dispositive from FERC's perspective when evaluating market manipulation liability. Remember, though, that FERC is still required to prove that a fraud was actually carried out to satisfy its prosecutorial burden.

3. What is the best defense against a market manipulation claim?

The best defense against a market manipulation claim directly rebuts an allegation of deceptive intent and/or that a fraud was perpetuated. Therefore, regardless of the complexity of the claim, the best defense establishes that a transaction (or series of transactions) had a "legitimate business purpose."

Of course, as market manipulation claims are fact-specific, so are defenses based on a legitimate business purpose. Yet FERC has not clearly defined what constitutes a legitimate business purpose but it has provided some useful guidance. Rather, FERC looks at facts and circumstances, including: (1) the existence or absence of a legitimate reason for the trading or hedging activity that is not tied solely to profit maximization; (2) the underlying reason for the relevant transaction and hedging activity; and (3) forecasts of market conditions that may impact the transaction or hedging activity.

4. What are my rights during an investigation?

The scope of your rights at FERC depends on whether you are involved in an investigation or an adjudication. FERC's investigative process has been detailed in prior issues of Public Utilities Fortnightly, and therefore will only be briefly summarized in this article.

Generally, investigations are inquiries into a potentially improper conduct. They begin with a review of conduct, followed by inquiries to the market participants (either informally or through a subpoena), the taking of testimony by FERC Enforcement Staff, a review of documents and data, and the development of preliminary conclusions as to whether subsequent adjudicatory proceedings are necessary.

By contrast, the adjudication process is the process where FERC has proposed to take a right away from you based on its finding during an investigation. Adjudications begin with an order from the Commission for the party under suspicion to "show cause." The subjects of investigations and Enforcement staff engage in discovery, briefing, argument, and a potential trial before an administrative law judge.

FERC's positon is that investigations do not implicate "due process" rights, but that does not mean that you have no rights whatsoever. For example, during an investigation, you are entitled to certain constitutional rights such as the Fifth Amendment right not to self-incriminate and the Sixth Amendment right to counsel. You also have the right to challenge subpoenas. A defendant, however, does not have a right to seek discovery, depose FERC witnesses and/or engage in the same type of exchange of information that would otherwise apply in adjudication.

5. What is an informal discussion with a regulatory agency such as FERC?

Our clients have sometimes been requested by federal regulators to engage in "informal" discussions. There is no such thing. All statements made to regulators during the course of an investigation are subject to 18 U.S.C. § 1001. This means that misstatements during informal discussions may subject a party to claims of perjury.

6. Where can I be sued?

The vast majority of FERC investigations settle. In such cases, FERC is the sole forum in which the investigations take place. Should a defendant litigate a claim, it may be heard before a FERC administrative law judge. However, a defendant may also elect to forego a FERC adjudicatory proceeding and defend their position in federal district court. This type of proceeding begins with FERC filing an action in federal district court to enforce a penalty ordered by FERC's Commissioners.

To date, only a few FERC market manipulation cases have been filed in federal district court (including the Barclays case discussed above) and they are currently being litigated. The scope of a federal district court's review of the underlying FERC record is currently subject to litigation. It is not clear if the reviewing court is required to accept the record developed by FERC, supplement the record as the reviewing court determines appropriate, or allow the parties to develop a new record for review by the court.

Regardless, under the relevant statue, the venue for a FERC penalty enforcement action is proper where "any act or transaction constituting the violation occurred" or where the defendant is an inhabitant. Barclays, whose trading desk is located in New York, challenged FERC's choice of venue in Eastern District of California, arguing that it is neither an inhabitant of the district nor performed any alleged violation there. The court rejected the Barclays argument, finding the California venue was proper because the transactions at issue caused electrons to move in and impacted prices in that district. Although this is just one case, the possibility that another inconvenient or distant district court might decide similarly needs to be considered. If, for example, your business is located in Florida but you are trading in California, a transaction made in California could result in you defending the trade in a California federal district court.

7. Can a company employee be held individually liable?

This inquiry remains an open question. FERC's anti-manipulation statute refers to "entities" rather than "people" or "companies." Many argue that because of the use of the term entity, FERC lacks jurisdiction to pursue market manipulation claims against natural persons. FERC has rejected this position and argues that an individual can and should be held personally liable for market manipulation. At this time, the Barclays decision is the only one addressing the issue. It concluded the term "entity" is broad enough to include natural persons and that such reading is most consistent with the goals of the Federal Power Act.

That means that individual senior management, middle management, and traders all could be found personally liable for company activities found to violate FERC's market manipulation rule. Thus, companies need to consider the potential for conflicts of interests between themselves and their employees during the course of a FERC enforcement action. Companies should be sure to adequately document their business strategy and the instructions given to traders in executing trades as a prophylactic measure for any potential future investigation.

8. How long does FERC have to bring a market manipulation claim?

The short answer is five years. The relevant statute, 28 U.S.C. § 2462, provides that actions for enforcement of civil fines or penalties must be instituted within five years of the date the claim first accrued, which, in the case of market manipulation, is the date of the underlying violation. Therefore, you have potential market manipulation liability for at least five years every time you execute a transaction. There is, however, an ability to enter into a tolling agreement with FERC if your company finds itself in an investigation.

9. What's important in designing a compliance program?

Companies need to understand FERC's enforcement program so they can implement successful compliance monitoring programs. Understanding the legitimate business purpose for each segment of your trading program is not only critical to defending a case, but also to building a compliance program. Companies need to monitor trading to evaluate its impact on market prices; ensure that statements to regulators and market monitors are accurate and complete; periodically evaluate emails in the trading department; and ensure that if served with a subpoena your document system has the appropriate mechanism to halt any destruction cycle.

10. What does it all mean?

Here are a two key points to remember.

First, FERC is moving aggressively, even against trades under established tariffs. FERC is policing markets, bringing fraud charges using open-ended statutes and claims focused largely on what FERC believes is the wrongful intent of market place participants. Arguing that a transaction was not intended to be manipulative is not a defense. Arguing that a transaction complied with a tariff is not a defense.

Second, companies need to understand FERC's investigative process. Management needs to understand how FERC builds its enforcement cases so they can defend themselves when necessary. If you understand FERC's program, then you are best armed and prepared when facing a FERC investigation, and when developing a compliance program.

Lead image © Can Stock Photo Inc. / kentoh