Individuals and organizations litigating the imposition of civil penalties by the Federal Energy Regulatory Commission (“FERC” or “Commission”) under its anti-manipulation authority in federal court received another opinion last week, this time from the Federal District Court for the District of Massachusetts, in what are commonly known as the “Paper Mill” cases.1 On April 11, 2016, the court denied motions to dismiss and for judgment on the pleadings filed as early as December 19, 2013 by Lincoln Paper and Tissue, LLC (“Lincoln”), Competitive Energy Services, LLC (“CES”), and Richard Silkman (together, “Defendants”).2 The decision is significant because it follows Judge Nunley’s decision in FERC v. Barclays Bank PLC et al., in the Eastern District of California as only the second time that a federal court has ruled on dispositive motions challenging FERC’s jurisdiction and the adequacy of its allegations in a civil penalty enforcement action under the Federal Power Act (“FPA”).
In the Paper Mill cases, FERC contends that Defendants violated the Commission’s Anti-Manipulation Rule and Section 222 of the FPA through a scheme artificially to inflate certain demand response payments from ISO-New England (“ISO-NE”). In three separate Orders Assessing Civil Penalties, each issued by FERC on August 29, 2013, the agency imposed civil penalties and ordered disgorgement payments against the Defendants totaling $13.15 million and $545,857.16, respectively.3
Defendants moved to dismiss FERC’s complaints, in which FERC asks the court to affirm its civil penalty assessments and disgorgement amounts in the consolidated Massachusetts proceeding. The court kept the motions under advisement for more than two years because their resolution hinged, in part, on the final adjudication of a challenge to FERC’s authority to regulate demand response. The Supreme Court held on January 25, 2016 that FERC has authority to regulate demand response, clearing the way for the Massachusetts court to decide the motions before it.4
When a party is subject to a FERC enforcement action, FPA Section 31(d)(3) allows it to choose how to proceed. The FPA provides that once FERC issues an Order to Show Cause (“OSC”), the defendant may elect either: a) to adjudicate the enforcement action in an agency proceeding before an Administrative Law Judge (“ALJ”), whose decision the Commission will review before deciding whether to impose penalties, or b) for the Commission to impose an immediate penalty assessment, if the Commission considers a penalty warranted, and to force FERC to initiate an “action in the appropriate district court” to collect penalties, wherein the court will engage in “de novo review [of] the law and facts.”5
There is no dispute between FERC and litigants that election of an administrative proceeding entitles a defendant to take discovery, present live testimony at a hearing and receive an independent decision from an ALJ. In contrast, FERC contends that electing de novo review in federal court means that a litigant is not entitled to any of the procedural protections available in an administrative proceeding. Rather, FERC asserts that the court may affirm the civil penalty assessment, without discovery or a trial, solely in consideration of briefing that is based upon what FERC calls an “administrative record,” which essentially comprises the briefing on the OSC and penalty assessment order. Unsurprisingly, there is a major disagreement between FERC and litigants on this issue, which, under FERC’s position, would mean the litigant would never be afforded procedural protections that would be available in an administrative proceeding. Resolution of the de novo review question and related issues pertinent to the nature of an adjudication of a FERC enforcement action in federal court is one reason why litigants are watching with great interest actions like the Paper Mill cases. This important case and the others like it raise issues of first impression that will shape the strategy litigants employ when challenging the validity of allegations in FERC enforcement actions.
Since Congress passed the Energy Policy Act of 2005 (“EPACT 2005”) and armed FERC with more potent civil penalty authority, companies and individuals facing FERC enforcement actions in electricity cases under the FPA have uniformly elected de novo review in federal court—presumably based upon the assumption that de novo review offers greater and certainly no less than comparable procedural safeguards to the alternative administrative proceeding option. Five cases are currently pending before federal courts on de novo review and in other public FERC enforcement actions that have not yet proceeded to federal court, the subjects have elected de novo review as well.
Only in the first of these cases to reach federal court, FERC v. Barclays Bank PLC. et al., has another dispositive motion to dismiss been decided. There, the Eastern District of California rejected the defendants’ jurisdictional and substantive arguments and denied their motions. Currently, the parties have briefed several important issues in recent filings (including the merits of FERC’s allegations, the sufficiency of FERC’s so-called administrative “record,” whether defendants’ waived their right to assert certain arguments, and the scope of de novo review) and are waiting for the court to set a date for oral argument on these issues.6
No substantive rulings have yet been issued in the other federal cases. In FERC v. Powhatan Energy Fund LLC et al., currently before the Eastern District of Virginia, the court denied defendants’ motion to dismiss, stayed discovery, and held oral argument on April 18, 2016 regarding the procedure mandated by FPA Section 31(d)(3).7 In FERC v. City Power Marketing, LLC et al., City Power Marketing and K. Stephen Tsingas filed a motion to dismiss FERC’s complaint to affirm its civil penalty assessment against the defendants in the District Court for the District of Columbia. And in FERC v. Maxim Power Corporation et al., the Massachusetts District Court is considering defendants’ motion to dismiss. In addition, Coaltrain Energy L.P. recently elected de novo review of FERC’s ongoing enforcement action against it.
Below we describe the Massachusetts court’s reasoning on the most important issues to this landscape.
Fraud as a Necessary Element for a Manipulation Violation
Beginning with the good news, the Massachusetts court in Silkman emphasized in dicta that fraud is a necessary element of a manipulation violation under the FPA and FERC’s Anti-Manipulation Rule. FPA Section 222 makes it unlawful “for any entity . . . directly or indirectly, to use or employ, in connection with the purchase or sale of electric energy or the purchase or sale of transmission services subject to the jurisdiction of the Commission, any manipulative or deceptive device or contrivance.”8 FERC’s Anti-Manipulation Rule, in turn, makes it unlawful to:
- 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.9
This statutory framework expressly requires proof of fraud as an element of a violation of the Anti-Manipulation Rule. However, FERC’s view appears to be that its rule captures alleged manipulations of any sort, including open market trading activity that complies with all applicable rules and tariffs, regardless of an express showing of fraud. FERC also claims, in some cases, that manipulative intent is sufficient to prove a violation even without proof of an artificial effect on the market. No federal court has yet decided the validity of FERC’s manipulation theories. Many parties currently litigating against FERC in federal court, however, argue that the agency is improperly targeting conduct that is not fraudulent and, as a result, not a violation of the Anti-Manipulation Rule. For example, Barclays argued in its motion to dismiss that its trading activity involved legitimate, open market transactions with willing counterparties that were “neither inherently deceptive nor fraudulent.”10 In the Powhatan motion to dismiss, the defendants also argued that their trades were neither deceptive nor fraudulent under FERC’s statutory scheme.11
The Massachusetts court made its pronouncements about the fraud-based nature of the Anti-Manipulation Rule in deciding whether FERC provided fair notice of what conduct it deemed unlawful. The court held that defendants had fair notice because their alleged conduct could be “deemed fraudulent” and therefore a violation of the Anti-Manipulation Rule. Quoting Black’s Law Dictionary, the court explained that fraud is “‘the knowing misrepresentation of the truth or the concealment of a material fact to induce another to act to his or her detriment.’”12 It explained that the alleged misrepresentations to ISO-NE (about Lincoln’s baseline level for demand response participation) were material misstatements. As a result of the alleged misrepresentations, Lincoln received substantial demand response payments. Moreover, the court emphasized, Lincoln allegedly knew that its conduct “was directly contrary to” the purpose of the demand response program because the company’s agent warned Lincoln about the program’s purpose.13 Entities against whom FERC seeks to impose civil penalties for conduct that is not as readily tied to express fraudulent misrepresentations may find useful language in this section of the decision.
“Entity” Includes Natural Persons under FPA Section 222
The Massachusetts court is the second court to decide that the term “entity” in FPA Section 222 includes natural persons. The court in Barclays decided the issue on May 20, 2015 as one of first impression.14 Each court concluded that the phrase “entity” in the FPA applies to individuals and cannot be used to block individuals from FERC’s jurisdictional reach. Although the courts reached the same conclusion, they arrived there in different ways. Contrary to the approach in Barclays where Judge Nunley afforded FERC no deference, the Massachusetts court deferred to FERC’s interpretation of “entity” as including natural persons.
The Massachusetts court also determined that, as a general matter, defenses to a civil penalty order may be waived if a party fails to raise them in response to a FERC OSC.15 In federal court cases involving de novo review, FERC frequently has asserted that the process it employs to decide whether to impose penalties is adversarial and therefore limits the arguments and evidence that federal courts should consider on de novo review.16 The Massachusetts court held that subjects of FERC enforcement actions may waive certain defenses if they are not raised in response to an OSC because the applicable FERC rule, 18 C.F.R. § 385.213, requires parties to raise every “practicable” defense in the agency proceeding.
Moving from general to specific, the court analyzed whether the defendants had waived their particular statute of limitations and jurisdictional defenses and held that they had not. The court concluded that it was not “practicable,” under the specific circumstances, to raise the statute of limitations defense during the agency proceeding where the limitations period had not even expired at the time of the administrative proceeding. Separately, the court held that the jurisdictional arguments “challenge[d] FERC’s power to issue the order that it seeks to enforce in the present action.”17
Market participants and the FERC defense bar will find the court’s general holding on this issue disappointing. The court seems not to recognize the near-impossibility, as a practical matter, of effectively raising and meaningfully disputing each fact in response to an OSC where, for example, the defendant has had no opportunity to conduct discovery. However, none of the court’s specific holdings on this point were adverse to the Defendants and the court’s limitation of its articulation of the general waiver rule to issues and facts that may “practicably” have been raised before FERC leaves the door open for future litigants in Massachusetts to argue that certain later-raised issues and facts could not have been raised below.
Additional Holdings and Key Issues
In addition to the holdings and issues described above, the Massachusetts court decided four other key issues.
First, the court held that Section 222 of the FPA and the Anti-Manipulation Rule do not make entities liable for aiding and abetting fraudulent conduct. The court concluded, however, that CES and Silkman could be directly liable if, as alleged, they perpetrated the fraud through false statements to ISO-NE.18 This holding could have meaningful ramifications for Silkman, CES and other subjects of FERC investigations who may be able to avoid liability that might otherwise attach under a more flexible aiding and abetting liability theory. Silkman and CES may now argue that for liability to attach to any of their conduct, FERC must show direct involvement in the furtherance of the fraudulent scheme.
Second, the court held that FERC’s complaint was timely because the agency initiated “formal proceedings,” by its July 2012 OSCs, within five years of the alleged violation. The court also addressed a second statute of limitations pertaining to the time within which FERC must bring an action to enforce a civil penalty that it assesses. Regarding this statute of limitations, FERC’s claim ripens for the enforcement of civil penalties in federal court once “there is a penalty to be enforced.”19
Third, the court determined that FERC’s manipulation allegations against Lincoln are sufficiently particularized to satisfy the heightened pleading standard under Federal Rule 9(b) of the Federal Rules of Civil Procedure because FERC “alleges the scheme that it believes to be fraudulent in detail” and provides “detailed times and factual allegations.”20
Fourth, and pursuant to the Supreme Court’s holding in EPSA, the Silkman court held that FERC has jurisdiction over the ISO-NE demand response program at issue in the complaints.21
In addition to its holdings, the Silkman court mentioned in dicta that the scope of de novo review under the FPA “may allow for the evaluation of evidence that was not part of the agency administrative record and may or may not require other trial-like proceedings.”22
The Order will disappoint observers who were hoping for a strong counterpoint to the approach taken by the Eastern District of California in the Barclays case. The Massachusetts court offered a mixed set of rulings, some of which may be useful to the defense bar and some of which may be more helpful to FERC. It left unclear what de novo review means, stating in dicta that under the FPA, it may be limited to something less than a full trial.23 Observers of FERC enforcement cases will have to continue to wait for a clear articulation from a court of what de novo review means under the FPA. In the meantime, it will be interesting to see whether parties continue to elect de novo review in light of the significant and perhaps growing uncertainty regarding the meaning of that important provision.