On May 29, 2015, the Federal Energy Regulatory Commission (“FERC”) issued an Order against Powhatan Energy Fund, LLC and its trading partners, Dr. Houlihan Chen, HEEP Fund, LLC and CU Fund, Inc. (together, “Powhatan”). FERC imposed civil monetary penalties of more than $29 million1 and disgorgement of nearly $5 million against the entities and a $1 million civil penalty against Dr. Chen for fraudulent trading in PJM Interconnection (“PJM”).2 FERC held that Powhatan violated section 222 of the Federal Power Act and section 1c.2 of FERC’s regulations (the “Anti‑Manipulation Rule”) by devising and executing a scheme to trade in a manner technically consistent with the PJM tariff but which violated the market design intended by the tariff.3 Among other arguments, FERC reasoned that profit-seeking alone is insufficient to protect a market participant from violating the Anti-Manipulation Rule—even when seeking profit, traders must not trade in a manner inconsistent with the purpose of an approved market design.
The Transactions at Issue and FERC’s Conclusions About Them
This order comes almost one year after FERC’s Office of Enforcement (“OE Staff”) released its August 2014 Staff Notice of Alleged Violations against Powhatan, in which it asserted that Powhatan engaged in a series of wash trades over the course of three months in 2010. Specifically, FERC alleged that Powhatan took advantage of PJM’s market design by engaging in round-trip Up To Congestion (“UTC”) transactions in the PJM energy market designed to avoid market risk and capture profits through Marginal Loss Surplus Allocation (“MLSA”) payments. UTC trades offer market participants the opportunity to arbitrage price spreads between day-ahead and real-time congestion prices at two different locations within PJM. A market participant whose UTC bid clears pays the difference between the day-ahead prices at locations A and B and receives the difference between the real-time prices at locations A and B.
FERC held that Chen, Powhatan’s head trader, violated the Anti-Manipulation Rule by matching UTC transactions with transmission reservations between two distant locations that appeared to be spread trades but that immediately canceled each other out. The trades were profitable because as cleared UTC transactions increased, reservation amounts under the PJM tariff increased and thus the share of MLSA payments increased.4 FERC concluded that the sole purpose of the trading was to capture MLSA payments and that Powhatan earned more than $5 million from these trades, affecting more than 100,000 MWh of electricity.5
Powhatan argued that the UTC transactions were legal, permissible, not fraudulent and executed for a legitimate economic purpose. Powhatan asserted that the fact that the trade volume did not balance equally in both directions showed that the trades were designed to expose Powhatan to market risk, and obtain market-based profits, rather than exclusively MLSA payments. Powhatan further reasoned that their trades had not disadvantaged other market participants because these participants were not entitled to the MLSA payments.6
Moreover, Powhatan argued that they engaged in these trades in response to price signals sent by the PJM tariff’s market design in an open and transparent manner. Powhatan said that PJM’s flawed market design motivated traders to profit from the tariff’s “loophole” and capture MLSA payments.7 Powhatan stopped short of admitting that this was their motivation, however, saying “maybe [it] was, maybe [it] wasn’t” Dr. Chen’s motivation.8 Regardless, Powhatan asserted that FERC should have corrected PJM’s market design rather than penalize Powhatan. Indeed, Powhatan casts this sort of loophole trading as a value to the marketplace because traders identify loopholes which, if corrected, improve market design and efficiency.
Powhatan also argued that FERC violated respondents’ due process rights by failing to provide fair notice that FERC would penalize market participants who take advantage of this known loophole in the system that had been discussed openly prior to the adoption of the surplus allocation rules. Powhatan reasoned that FERC’s orders approving the tariff foresaw the anticipated consequences of PJM’s market design and yet FERC approved the market design.9 Powhatan argued that FERC “has the responsibility to state with ascertainable certainty what is meant by the standards [it] has promulgated.”10 Moreover, Powhatan asserted that their trades were permitted by the PJM Tariff and that FERC did not preclude round-trip UTC trades from capturing MLSA payments in a prior proceeding.11 As a result, Powhatan reasoned, FERC did not provide fair notice that the UTC trades were improper.
In the January 2015 Response to FERC’s Order to Show Cause, Powhatan elected to receive an immediate penalty assessment and recently stated that they will not pay the penalty. Powhatan’s position places the onus on FERC to seek enforcement of its penalty in federal district court where the court will review FERC’s decision de novo, if the respondents indeed refuse to pay.12
FERC rejected all of Powhatan’s arguments and held the respondents liable for violating the Anti-Manipulation Rule. FERC concluded that “[t]he fact that the PJM tariff does not explicitly prohibit round-trip UTC trades does not create a loophole or otherwise render [Powhatan’s] transactions lawful.”13 It reasoned that a tariff cannot explicitly prohibit every kind of fraudulent behavior.14 FERC also asserted that Powhatan understood PJM’s market was designed to incentivize the convergence of day-ahead and real-time markets. Despite this awareness, Powhatan engaged in UTC transactions that constituted prohibited wash trades and that did not have the convergence effect that the PJM market intends. Rather, FERC concluded, Powhatan’s trades were designed solely to receive MLSA payments. FERC argued that market participants should seek profits based on market fundamentals, but not on the basis of out-of-market payments like MLSAs.
Moreover, FERC distinguished two cases raised by Powhatan in which FERC exercised more leniency towards traders investigated for similar trading.15 It noted that the market participants in those cases had responded either to actual price differences in making their spread trades or had approached FERC before engaging in similar conduct and received initial approval that was later withdrawn. FERC emphasized that Powhatan, by contrast, had not consulted FERC before making the purportedly fraudulent trades.
The Penalty Calculation
In calculating Powhatan’s base penalty, FERC adopted OE Staff’s recommended increase to Powhatan’s base levels after determining that (1) the participants had full knowledge of the fraudulent trades and (2) the scope of the violation, based on volume and duration, was considerable. FERC also adopted OE Staff’s recommendation that Powhatan’s penalty reflect Powhatan’s failure to accept responsibility for its conduct.16 While accepting OE Staff’s penalty, FERC determined that OE Staff erred in calculating recommended penalties based on unjust profits rather than on total losses resulting from the alleged violations.17 FERC noted that Powhatan’s trading activity caused losses of nearly $9 million, a figure significantly higher than the approximately $3 million Powhatan purportedly obtained in unjust profits.18 Despite this difference, FERC ultimately determined to “exercise [its] discretion and accept OE Staff’s proposed penalty, which falls within the applicable Penalty Guidelines range.”19
The positions taken by Powhatan and FERC during the course of the investigation leading to the penalty assessment reflect fundamentally different views of the rules governing market participants in FERC-regulated energy markets. FERC’s penalty assessment makes clear that it expects market participants not only to abide by explicit rules but also to refrain from actions that undermine the intended results of the market design. This “intent of the market design” concept poses a significant challenge for market participants and highlights the continued importance of robust compliance programs that consider all aspects of a trading strategy, including perceptions of intended market design. Perhaps the anticipated de novo review in federal court will provide greater clarity to market participants on this enforcement risk in FERC-regulated power markets.
Under the supervision of the authors, Alex Hokenson, a summer associate at Cadwalader, provided valuable research and input into the drafting of this Clients and Friends Memorandum.