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Confusion Over FERC Rules Will Remain After Powhatan
Law360, New York (June 11, 2014, 11:59 AM ET) -- On Feb. 28, 2014,
Powhatan Energy Fund launched a public website disclosing that for more
than three years, theFederal Energy Regulatory Commission's Office of
Enforcement has been investigating Powhatan for alleged manipulation of
the PJM Interconnection energy market.
According to FERC OE’s preliminary findings, Dr. Houlian Chen, trading on
behalf of Powhatan, himself and others, manipulated PJM’s energy market by
taking advantage of a market loophole that permitted payments to Powhatan
despite unprofitable up-to-congestion transactions. Powhatan claims FERC’s
investigation violates due process because before the investigation began, no FERC order or express
regulation put Powhatan on notice that the trades were unlawful. Furthermore, Powhatan maintains
that its UTC transactions were open and transparent — without concealment or misrepresentation —
and it is not manipulative to take advantage of market flaws. Six months after Chen’s first trades were
executed, FERC changed the rules to close the loophole.
The investigation continues, but for the first time in recent history, a company has publicized a
nonpublic FERC investigation as part of its defense strategy. Powhatan released FERC OE’s document
preservation directive, data requests, preliminary findings and Powhatan’s responses. Usually, FERC’s
nonpublic investigations become public only after the OE’s inquiry has progressed to a later stage and
settlement agreements are approved or when FERC issues publicly a notice to show cause or notice of
alleged violation, which has not yet occurred.
Powhatan’s going public first has disrupted the “usual process.” Powhatan’s founders have explained
"the government wields tremendous power” when they threaten market manipulation charges and
going public "was an insurance policy” to protect our personal and professional reputations.[1]
According to the press, Powhatan’s founders have “embarked on a public campaign” to stop Norman
Bay, FERC’s Enforcement Director, from being confirmed as the next commission chairman. Indeed, the
issue of heavy-handed enforcement played out during Bay’s Senate confirmation hearing on May 20.
And the Allegation Is ...
FERC alleges that from February 2010 to August 2010 Chen manipulated the PJM market by matching
UTC transactions with transmission reservations to collect marginal loss surplus allocation (“MLSA”)
payments with "the intent to avoid the effects of price changes in the market."[2] A UTC transaction is
“a virtual transaction that earns or loses money on the change between the day-ahead market (“DAM”)
and the real-time market (“RTM”) of the spread in prices between two price nodes in PJM’s system.”[3]
Until September 2010, every trader who scheduled a UTC transaction was first required to reserve the
transmission hours necessary for the intended UTC scheduled transaction. Each confirmed reservation
would receive a transmission reservation ID which would be used to place bids on the UTC
transaction.[4] Due to scheduling the UTC transactions, traders would incur reservation costs and
ancillary costs for market support, market monitoring and secondary control center assessments.
Reservation costs averaged $0.17 per megawatt-hour and ancillary costs varied from $0.03 to $0.05 per
MWh.[5]
PJM applies the marginal loss method to transmission line loss charges that are included in the per MWh
price of electricity in PJM’s electricity market. According to PJM’s September 2009 tariff schedule,
“MWhs of successfully scheduled trades associated with paid-for transmission in a given hour received a
proportionate share of the surplus collected throughout the entire PJM market for the hour” —
otherwise known as MLSA.[6]
On Sept. 17, 2009, PJM decided to pay retroactively MLSA distributions for the prior 15-month period
and reflected those payments on the settlement statements from November 2009 to February 2010. All
eligible MWhs, including UTC transactions, received MLSA payments and PJM distributed the surplus
transmission line loss collections among all eligible MWhs, irrespective of the transmission service type
or service cost differences.[7]
According to FERC's OE, Chen identified node pairs where “changes in the price spread between the
DAM and RTM consistently produced a de minimis profit or loss, or created wash-like or sham pairs of
transactions with price spread changes that netted to a zero or near-zero profit or loss.”[8] Therefore,
according to OE, Chen designed and used “UTC transactions scheduled against transmission reservations
as a vehicle to receive MLSA.”[9]
FERC OE estimates that from February 2010 to August 2010 Chen made more than 18 million MWh of
transmission reservations associated with 19.5 million MWh of UTC transactions and nearly 10 million
MWh were eligible to receive the MLSA payments.[10] Due to Chen’s trading, the trades lost more than
$6.7 million, but earned almost $11.5 million in MLSA payments, resulting in approximately $4.8 million
in total net profit.[11]
Market Design Flaws and Market Manipulation
FERC prohibits entities from directly or indirectly using any device, scheme, artifice, act, practice or
business that operates or would operate as fraud or deceit upon any entity in connection with the
purchase or sale of electric energy or transmission services subject to FERC’s jurisdiction.[12] Market
manipulation is established by evidence of: (1) use of a fraudulent scheme, device, or artifice or material
misrepresentation; (2) with the requisite scienter; (3) in connection with the purchase or sale of electric
energy or the transmission of electric energy subject to FERC’s jurisdiction.[13]
Powhatan and FERC's OE seemingly agree that the commission has jurisdiction since PJM is a FERCapproved regional transmission organization and an independent systems operator and Chen’s UTC
transactions occurred within PJM’s market. However, Powhatan rejects FERC OE’s allegation that Chen’s
trades involved a fraudulent scheme or material misrepresentation and were undertaken with the
requisite scienter for market manipulation.
FERC's OE relies on the U.S. Securities and Exchange Commission case In re Amanat, in which the Third
Circuit affirmed, “manipulation may exist under Regulation 10b-5 where trades are sham trades
designed to avoid the effects of price changes due to market forces.”[14] OE staff concluded Chen’s UTC
trading was not designed to make money according to market dynamics, but instead designed so that
the UTC trades to profit from the large volume of eligible MWh that received MLSA payments.[15]
Furthermore, the OE states Chen’s trading UTC trading activity was “uneconomic,” thus violating antimanipulation rules.[16]
Powhatan counters that Chen’s UTC trades were legitimate transactions authorized by PJM’s tariff and,
unlike wash-like transactions, each transaction had its own risks. Powhatan cites instances where Chen
lost money on certain UTC transactions, when the prices did not move in a manner that he had
anticipated. Importantly, Powhatan argues that there is a fundamental difference between illegally
engaging in market manipulation and legally taking advantage of a defective market design. Powhatan
maintains that Chen’s trades may have benefited from a defect in PJM’s market design, but Chen’s
trades violated no law and involved no fraud or fraudulent intent.
FERC's OE rejects Powhatan defenses because in other cases the commission states that “improper
intent alone may transform what appears to be a legitimate market transaction into prohibited
manipulation.”[17] FERC's OE references other commission cases in which market participants who
acted contrary to their economic interests fell within the zone of manipulative activity.
FERC's OE believes that the evidence establishes the required scienter for market manipulation. During
his deposition, Chen testified that he selected PJM nodes with similar historic price movements to limit
the spread risk between the DAM and RTM.[18] After Chen and Powhatan founders realized the
profitability of Chen’s trading strategy, they created the Powhatan fund specifically to benefit from
PJM’s market design flaw. In separate testimony, a Powhatan partner’s acknowledged that the only risk
in Chen’s UTC trades was “a new risk that the [MLSA] revenues would exceed the costs associated with
the trades.”[19] According to OE, a Powhatan partner advised another party to keep the UTC
transactions “strictly confidential” since “just knowing about this inefficiency is our only edge.”[20]
Powhatan argues that Chen and the company did not intend to manipulate PJM’s electricity market, but
rather benefit from PJM’s defective tariff’s design. Powhatan compares Chen’s UTC trading activity to
high-frequency trading activities permitted by the SEC. Powhatan insists that FERC OE staff is violating its
due process rights since neither Chen nor Powhatan were on notice that receiving the MLSA payments
from UTC transactions violated FERC rules as the payments were fully sanctioned by PJM. Only later did
PJM change the tariff design to exclude UTC transactions from MLSA payments.
FERC's OE dismisses Chen and Powhatan’s scienter defenses for two reasons. First, deposition testimony
and other evidence corroborates the OE staff’s conclusion that Chen’s UTC trading activity were not
subject to genuine market risks, because by matching the node pairs (i.e., A to B and B to A), Chen
brought the risk spread to near zero.[21] During the relevant trading period, Chen and Powhatan
expressed concern that the MLSA payments may be incorrect and that one possibility would be that
they would be in “big trouble” or have to retroactively repay some of the payments.[22] Finally, the OE's
staff emphasizes that MLSA proceedings and FERC’s statement in Black Oak Energy clearly said FERC
wanted to avoid a market rule in which “arbitrageurs can profit from the volume of their trades.”[23]
Current State of Play and Takeaways
FERC's OE noted that “it is unaffected by the outcome” of Powhatan’s plan to release the information
publicly. Powhatan’s website summarizes the exchanges between FERC and Powhatan’s legal
representatives, includes position papers from 12 independent experts and presents Powhatan’s claims
that FERC OE staff has unfairly targeted the company.
FERC's OE has aggressively investigated loss-leader/relational trading and outright fraud as well as
behavior that appears responsive to market signals and compliant with existing tariffs. The Powhatan
case challenges FERC’s scienter requirement for market manipulation and questions whether market
participants have a duty to report, ignore or otherwise not act upon market design flaws.
The outcome likely will result in yet more mixed signals regarding what market participants may or may
not do when following the existing rules. This adds further risk to market participation. Although the
investigation remains open, it is clear that following the tariff rules is insufficient to avoid FERC scrutiny
regarding market manipulation. Nevertheless, Powhatan’s own public disclosure of FERC OE’s nonpublic
investigation puts the commission and its staff on notice that it is no longer “business as usual” in
response to alleged violations.
—By Gregory K. Lawrence and Lynna J. Cobrall, Cadwalader Wickersham & Taft LLP
Gregory Lawrence is a partner in Cadwalader Wickersham & Taft's Washington, D.C., office.
Lynna Cobrall is a law clerk in Cadwalader Wickersham & Taft's New York office.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its
clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general
information purposes and is not intended to be and should not be taken as legal advice.
[1] Tom Schoenberg et al. Hedge Fund Twins Stage Campaign Against Energy Regulator. Bloomberg.
(April 10, 2014)
http://www.bloomberg.com/news/2014-04-10/hedge-fund-twins-stage-campaign-against-energyregulator.html
[2] FERC Preliminary Findings on Powhatan p. 2-3. (Aug. 9, 2013) http://ferclitigation.com/wpcontent/uploads/0005-FERC-Preliminary-Findings-August-9-2013-2002899_1.pdf
[3] Id. at 3.
[4] Id. at 4.
[5] Id.
[6] FERC Preliminary Findings on Powhatan p. 5. (Aug. 9, 2013) http://ferclitigation.com/wpcontent/uploads/0005-FERC-Preliminary-Findings-August-9-2013-2002899_1.pdf
[7] Id.
[8] Id.
[9] Id.
[10] FERC Preliminary Findings on Powhatan p. 18. (Aug. 9, 2013) http://ferclitigation.com/wpcontent/uploads/0005-FERC-Preliminary-Findings-August-9-2013-2002899_1.pdf
[11] Id.
[12] 18 C.F.R. 1c.2 (2009).
[13] Prohibition of Energy Market Manipulation, Order No. 670, 114 FERC ¶ 61,047 at p. 49 (2006) .
[14] In re Amanat, 89 S.E.C. Docket 672, Admin. Proc. File No. 3-11813, 2006 WL 3199181, at *1-7 (SEC
Nov. 3, 2006), aff’d mem. Sub. Nom. Amanat v. SEC, 269 Fed. Appx. 217(3d Cir. 2008) (footnotes
omitted).
[15] FERC Preliminary Findings on Powhatan p. 21.(Aug. 9, 2013) http://ferclitigation.com/wpcontent/uploads/0005-FERC-Preliminary-Findings-August-9-2013-2002899_1.pdf
[16] On Feb. 1, 2013, FERC approved a Stipulation and Consent Agreement with Oceanside Power, LLC
for engaging in UTC transactions. The settlement included a disgorgement of $29,563 and a civil penalty
of $51,000. 142 FERC ¶61,088 http://www.ferc.gov/enforcement/civilpenalties/actions/142FERC61088.pdf
[17] Id. at note 15 citing Brian Hunter, 135 FERC ¶ 61, 054, P 50 (2011) 9 “The difference between
legitimate open-market transactions and illegal open market transactions may be nothing more than a
trader’s manipulative purpose for executing such transactions.” See also Markowski v. SEC, 274 F.3d
525, 529 (D.C. Cir. 2001)(“manipulation can be illegal solely because of the actor’s purpose.”
[18] FERC Preliminary Findings on Powhatan p. 22. (Aug. 9, 2013) http://ferclitigation.com/wpcontent/uploads/0005-FERC-Preliminary-Findings-August-9-2013-2002899_1.pdf
[19] Id. at 14.
[20] Id. at 16.
[21] Id. at 13.
[22] FERC Preliminary Findings on Powhatan p. 11. (Aug. 9, 2013) http://ferclitigation.com/wpcontent/uploads/0005-FERC-Preliminary-Findings-August-9-2013-2002899_1.pdf
[23] Id. at 27 citing Black Oak Energy LLC v. PJM Interconnection LLC, Order Denying Complaint, 122
FERC ¶ 61, 208 at
P. 51 (2008).
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