The wake of the Amaranth Advisors LLC (Amaranth) energy market scandal has swelled support for legislation to close the “Enron-loophole,” a perceived regulatory gap in the Commodities Futures Trading Commission’s (CFTC) authority to enforce anti-manipulation rules against energy traders using electronic exchanges and the over-the-counter (OTC) market for energy derivatives.1 The Enron-loophole was created in 2000 when, at the request of Enron Corporation and others, Congress amended the Commodity Exchange Act,2 to exclude CFTC oversight of OTC transactions or energy commodities traded on electronic energy exchanges. Consequently, trades on a leading U.S. electronic energy exchange, Intercontinental Exchange (ICE),3 are exempt from regulatory oversight that applies to regulated exchanges like the New York Mercantile Exchange (NYMEX).4
Hedge fund behemoth Amaranth imploded after losing over $6 billion on natural gas futures contracts last September. Amaranth primarily traded gas futures in the unregulated futures and OTC markets on ICE. The giant’s downfall caught the CFTC’s and FERC’s attention resulting in both agencies aggressively pursuing enforcement actions against Amaranth.5 Under the guise of its broad anti-manipulation authority granted by the Energy Policy Act of 2005, FERC initiated an investigation into Amaranth’s gas futures trading schemes which FERC asserts had a calculated impact on the physical gas markets. Notwithstanding the fact that Amaranth was not participating in the physical gas market, FERC issued a show cause order requiring Amaranth to show why it should not be fined up to $29.1 million for alleged market manipulation. Amaranth is also subject to a civil enforcement action by the CFTC based on allegations that Amaranth unlawfully attempted to manipulate the price of natural gas futures contracts on NYMEX. The CFTC charges that Amaranth manipulated the NYMEX market by trading natural gas future contracts on NYMEX in a manner intended to lower the price of such contracts to benefit Amaranth’s larger swap positions it held on ICE. The CFTC is seeking fines up to $130,000 per questionable trade and triple damages for any profits made off such trades.
The CFTC’s and FERC’s seemingly duplicative prosecution of Amaranth have sparked much debate over whether legislation is needed to close the Enron-loophole, whether the FERC has overstepped its jurisdiction by pursuing Amaranth, and whether the CFTC needs broader enforcement authority. The perceived failures of the CFTC’s regulatory oversight regime highlighted by Amaranth’s fall likely will result in legislation during this session of Congress. Such legislation could have the indirect effect of delineating the respective agencies’ jurisdictions over enforcement actions arising out of trading futures and other energy derivatives on electronic exchanges and in the OTC markets.
This is not the first time the respective roles of the FERC and CFTC have been called into question. In the Enron aftermath, various industry watchdogs and legislators, including Senator Joseph I. Lieberman, then Chairman of the Senate Governmental Affairs Commission, questioned whether action was needed to clarify the jurisdictional boundaries between FERC and the CFTC regarding energy trading activities and products, including online trading, and to better define the two agencies’ respective market monitoring responsibilities in these developing markets. Despite these red flags raised in 2002, no legislation was passed to strengthen the CFTC’s enforcement role over OTC trades and electronic exchanges. In fact, as late as March 2006, CFTC Commissioners resisted legislative efforts to impose additional regulations on energy futures and OTC markets, saying calls for “heighten market surveillance and more price reporting from various types of gas markets raise jurisdictional and resource issues that create moral hazards for market users and the CFTC.”6
Today, as lawmakers cast the same criticisms of the CFTC as heard in 2002, the CFTC has reacted with a lobbying effort seeking broader regulatory authority over energy derivatives traded on electronic exchanges and in the OTC markets. In July 9, 2007, the Senate summed up its findings from hearings on the Amaranth scandal, concluding:
The flaws in the current regulatory structure for U.S. energy trades are painfully obvious, but the CFTC has been slow to call for reform. For years, the CFTC has resisted requesting authority to monitor energy trades taking place outside the regulated markets. It has resisted recognizing the role of unregulated markets in affecting prices on regulated markets and the impact of excessive speculation in pushing up energy prices. It has also resisted asking for explicit authority to prevent price manipulation and excessive speculation on ICE. Amaranth’s excesses may have finally broken down some of that resistance.7
Congress is now questioning why any organized exchange with energy trading such as ICE is treated differently from NYMEX and is exempt from routine CFTC oversight and regulation.8
Indeed, the recently appointed acting Chairman of the CFTC, Walter Lukken,9 points to the fact that electronic trading on OTC futures markets has soared to sixty percent of total futures trading volume in 2007, as justification to seek increased oversight and clarification of the CFTC’s duties with respect to anti-manipulation authority over transactions in energy commodities.10 Chairman Lukken has stated that “[t]he evolution of these energy markets in recent years requires our agency to address whether the level of regulatory oversight is proper given the importance of energy prices to all Americans.”11 Lukken has testified to Congress that the futures markets have changed dramatically since the creation of the Enron-loophole, namely that the regulated futures markets and exempt commercial markets have become increasingly linked.12 Lukken believes the CFTC is nearing the outer limits of its authority to adequately oversee these markets.13 Lukken also has noted that there is an “absence of a bright-line delineation of the boundaries of [FERC’s and CFTC’s] authorities.”14 Chairman Lukken’s testimony suggests that at least some industry participants believe that legislative action is needed to more clearly define FERC and CFTC’s enforcement roles.
The likely vehicle for Congress to act is through the reauthorization process. The CFTC is subject to periodic reauthorization from Congress; its current authority expired on September 30, 2005. Congress often uses the reauthorization process to update the Commodity Exchange Act (CEA) to reflect the evolution of the financial markets. 15 It is anticipated that the current 110th Congress will enact legislation reauthorizing the CFTC and that it may take the opportunity to clarify or broaden CFTC’s regulation of energy derivatives markets. The proposed, but unenacted reauthorization bills from the 109th Congress and a pending bill to amend the CEA sheds some light on what changes the may be expected.16
Based on prior bills, any legislative action would aim to increase natural gas price transparency. For example, the Oil and Gas Trader’s Oversight Act of 2007,17 seeks to add a provision to the CEA to require energy traders on exempt electronic exchanges to keep records and report large positions for at least five years and to make these record available to the CFTC upon request. The CFTC Reauthorization Act of 2005 sought to increase transparency of natural gas prices by requiring: (i) the CFTC to conduct surveillance of trading in natural gas contracts and review significant and highly unusual changes in the settlement price of any physically delivered natural gas futures contract and (ii) any person holding or controlling any position in a natural gas futures contract at or exceeding reportable limits, to maintain and provide, upon CFTC request, related records for five years. Besides increasing transparency, prior bills also proposed to increase the CFTC’s civil penalty authority for specified commodity market manipulation-related offenses to $1 million, or triple the monetary gain for each violation. Bills also have sought to clarify that the CFTC’s antifraud authority applies to “principal-to-principal” off-exchange derivatives contracts.
These legislative changes would serve to close, or at least narrow, the Enron-loophole that is perceived to exist for energy derivatives traded on electronic exchanges and in the OTC markets. Any such legislation also may tacitly underscore CFTC’s primary jurisdiction over these financial markets and, thereby, help clarify the CFTC’s and FERC’s respective enforcement roles over energy derivative traders like Amaranth