March 11, 2014 Articles

Enforcement Shifts Energy-Trading Strategies

Finding the sweet spot between maximizing profits and mitigating risks will be more challenging.

By Julie Carey, Cliff Hamal, and Ben Ullman – March 11, 2014

Since 2012, the Federal Energy Regulatory Commission (FERC) and Commodity Futures Trading Commission (CFTC) have levied hundreds of millions of dollars in fines against companies for violating commodity-market rules, including, most notably, each agency’s market-manipulation statutes. In most instances, the fines focused on market-participant behavior involving trading activities within both the physical and financial markets, such as financial-market trading activities that benefit positions in physical markets. The dramatic increase in enforcement actions is coupled with regulators hiring more staff and increasing the volume and type of data available for their review. These changes represent a shift toward more active oversight at the agencies and suggest greater enforcement risks for today’s complicated physical- and financial-market trading activities. Yet, even with identification of this new risk, the way in which trading will adapt to this heightened focus on manipulation remains to be seen.


Both FERC’s and CFTC’s current energy-market-manipulation rules are based on Rule 10b-5 of the Securities and Exchange Commission (SEC). Rule 10b-5 is open-ended by design, and while there are decades of SEC case-law precedent, FERC and CFTC have only recently undertaken cases and drafted public orders of their interpretations. With a small but growing set of case records, FERC’s and CFTC’s intent and desire to enforce the energy-market-manipulation rules are evident, even though clear definitions of what conduct constitutes market manipulation have not emerged. While the agencies have not issued bright-line tests, they have shown a consistent interest in participant behavior, intent, and market fraud.

The table below details recent cases involving allegations of energy-market manipulation and related violations of trading rules. In addition to FERC and CFTC actions, there are a handful of newly filed class-action lawsuits with claims that BP PLC, Royal Dutch Shell PLC, and Statoil ASA manipulated Brent crude-oil prices and futures contracts. The Federal Trade Commission (FTC) also has an open investigation of these trading activities.

Recent Energy Commodity Market Settlements and Cases


Company

Agency

Commodity

Fine 
($Millions)

Date

Note

Barclays

FERC

Electricity

470

4/16/2013

1

JP Morgan

FERC

Electricity

410

7/30/2013

Constellation

FERC

Electricity

245

3/9/2012

Brian Hunter/Amaranth

FERC

Natural Gas

30

4/21/2011

2

BP

FERC

Natural Gas

29

8/5/2013

3

Optiver Holdings

CFTC

Oil

14

4/19/2012

Rumford Paper

FERC

Electricity

10

3/22/2013

Competitive Energy Services

FERC

Electricity

7.6

8/29/2013

Lincoln Paper

FERC

Electricity

5.4

8/29/2013

Gila River

FERC

Electricity

3.5

11/19/2012

Deutsche Bank

FERC

Electricity

2.2

1/22/2013

Richard Skillman

FERC

Electricity

1.25

8/29/2013

4

Enerwise

FERC

Electricity

0.8

6/7/2013

Daniel Shak

CFTC

Oil

0.4

11/25/2013

4

Arcadia/Parnon

CFTC

Oil

Pending

5/24/2011

Royal Dutch Shell

FTC

Oil

Pending

2013

Statoil ASA

FTC

Oil

Pending

2013

Notes:

1. Case to be tried in court

2. Case overturned due to jurisdictional issues

3. Case unsettled

4. Individual, rather than corporation

The Evolving Regulatory Environment
The recent surge in energy-manipulation allegations follows two decades of market developments. First came deregulation of the natural-gas and electricity industries, then an evolution in trading, and, finally, sweeping regulatory changes in response to these changes in trading. The rules were originally based on bilateral transactions for physical futures, and evolved to contemplate centralized markets, complicated portfolios of physical and financial products, and algorithmic trading of financial derivatives.

FERC played catch-up in policing participant behavior related to energy markets following the meltdown of the California electricity market, and adopted formal Market Behavior Rules in 2003. Under the Market Behavior Rules, market manipulations were deemed “actions or transactions that are without a legitimate business purpose and that are intended to or foreseeably could manipulate market prices, market conditions, or market rules.” In 2006, pursuant to the Energy Policy Act of 2005, FERC changed its manipulation rules to mirror the aforementioned SEC Rule 10b-5, which focuses on perpetuating fraudulent behavior in a market with requisite intent (also referred to as scienter).

The change provided FERC with increased flexibility to pursue what it considers “bad acts,” a larger pool of cases from which to draw precedent, and greater penalty authority (limits increased from $10,000 to $1 million per violation per day). In addition to broader authority, FERC improved its access to market-participant-level data and substantially increased staffing levels to investigate manipulation allegations.

CFTC’s ability to investigate possible manipulations of the energy market dramatically increased in 2010 with the passage of the Dodd-Frank Act. Prior rules required manipulation findings to include a demonstration of a market-price effect. In 2010, this requirement was relaxed to also allow a manipulation finding based on “an attempt to defraud.” Similar to FERC, CFTC invested in technology and analytical resources to increase surveillance efforts.

In addition, the Federal Reserve is currently reviewing the role and activities of investment banks in physical-commodity trading activities. Currently, investment-bank authority to participate in those markets through behavior such as trading and warehousing of commodities (including energy products) is under review at the Federal Reserve. Whether or not the provisions (that allow these activities) will continue to exist is currently uncertain.

The common theme in all of these actions, whether taken by Congress, FERC, CFTC, or the Federal Reserve, is that heightened attention and more vigorous regulatory actions are needed to ensure that the public interest is served. It is fair to say that this increased vigilance is part of a broader shift in policy to rein in certain financial activities that are viewed as more problematic than productive. In this environment, some firms, including JPMorgan Chase, Hess Corp, Oneok, and GDF Suez, recently announced their exit from the physical-commodity trading business.

What Will Future Enforcement Look Like? 
The future holds a substantially increased risk of enforcement actions for questionable trades under FERC or CFTC jurisdiction. Regulatory commitments, coupled with increased legal authority to monitor market activity and litigate claims, will likely lead to more investigations, more information requests, and more prosecutions. Regulators’ ability to independently find challengeable behavior and initiate investigations is unprecedented in these markets—and it would be naive to think they will not use it.

There are strong reasons to believe that the increased oversight will focus on trading activity itself, rather than on the types of communications (e.g., emails) that have proven critical in so many prior investigations. For example, recent FERC enforcement actions indicate that trading data can be heavily relied on to meet the intent requirements of the manipulation rules. FERC concludes that players active in these markets should know the impacts of their actions, and cites SEC precedent that willful ignorance of an effect on a market can be considered reckless and therefore satisfy the scienter requirement of a manipulation finding. Further, FERC indicates that there are no strict tests that can be applied to discern manipulative from non-manipulative behavior.

In the absence of strict criteria for defining manipulation, past enforcement actions serve to provide guidance on regulatory-oversight strategy. Both CFTC and FERC have pursued cases involving trading strategies in which physical trades regularly lost money while corresponding financial positions benefited. Similar patterns of unprofitable trading activities, especially when those activities are sustained and represent a shift from prior patterns, are likely to generate inquiries from regulators. It should be noted, however, that while FERC considers a disregard for losses a possible element in a recklessness finding and will consider losses as a part of evidence, it also has made explicit that losses are not a necessary condition for a manipulation finding (Deutsche Bank decision). More important than profitability is the strategy at issue and the pattern of trading.

As a result of the shifting enforcement landscape, energy-commodity traders are reassessing trading strategies and market participation. Finding the sweet spot between maximizing profits from trading activities and mitigating regulatory-oversight risks will be more challenging for the foreseeable future.


Keywords: energy litigation, manipulation, FERC, CFTC, commodities, trading, enforcement


Julie Carey is a director, Cliff Hamal is a managing director, and Ben Ullman is a managing consultant with Navigant Consulting in Washington, D.C.

 

Navigant Consulting is the Litigation Advisory Services Sponsor of the ABA Section of Litigation. This article should be not construed as an endorsement by the ABA or ABA Entities.

 


Copyright © 2014, American Bar Association. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. The views expressed in this article are those of the author(s) and do not necessarily reflect the positions or policies of the American Bar Association, the Section of Litigation, this committee, or the employer(s) of the author(s).