On September 30 2011 the Department of Justice (DOJ) announced a settlement with Morgan Stanley, describing it as a "signal to the financial services community that use of derivatives for anticompetitive ends will not be tolerated".(1) The proposed consent agreement in United States v Morgan Stanley(2) requires disgorgement of $4.8 million in Morgan Stanley profits from an electricity market hedge arrangement that the DOJ alleged violated Section 1 of the Sherman Act.(3) In 2010 DOJ sued KeySpan Corporation, an electric power generator, alleging that KeySpan used the same hedging arrangement to avoid price competition in the New York City electricity market. KeySpan was required to disgorge $12 million of profit.(4) The Morgan Stanley case holds the financial services company responsible for having facilitated and profited from the anti-competitive hedging arrangement.

The key points from the case for financial services clients are:

  • The DOJ is prepared to use Section 1 to outlaw financial arrangements aimed at producing anti-competitive effects;
  • The DOJ will take enforcement action against the financial services companies that facilitate those arrangements, even though they do not participate in the underlying physical commodity market; and
  • Pure financial players may have a duty to examine the competitive effects of their arrangements on the underlying markets.


KeySpan was the largest supplier of electricity generating capacity in the highly concentrated New York City market.(5) From 2003 to 2006 KeySpan routinely "bid the cap" (ie, offered to sell all of its generating capacity at the highest allowable price level established by New York's rate-setting agency) and still sold nearly all of its capacity. In 2006 additional generating capacity entered the market, and more aggressive price competition was expected. When prices did not fall as expected, a DOJ investigation followed, resulting in a complaint and settlement with KeySpan in 2010.(6)

KeySpan's response to the anticipated additional price competition was initially to pursue the acquisition of the generation assets of its largest competitor, Astoria, which would have enabled it to continue bidding the cap – thus keeping prices high. Concurrently, Morgan Stanley was exploring the purchase of Astoria's capacity assets and was seeking a strategic partner. Morgan Stanley and KeySpan discussed the possibility of partnership. Ultimately, KeySpan concluded that acquiring its largest competitor would raise serious market power issues and shared this view with Morgan Stanley. According to the DOJ, instead of purchasing the Astoria assets, KeySpan decided to acquire a financial interest in Astoria's generating capacity through a derivative arrangement with Morgan Stanley. Morgan Stanley agreed to serve as the counterparty on the condition of its ability to enter into an offsetting agreement with the owner of the Astoria assets.

On January 9 2006 Morgan Stanley finalised the terms of two financial derivative arrangements: the KeySpan Swap and the offsetting Astoria Hedge. Under the KeySpan Swap, if the market price for generating capacity went above $7.57 per kilowatt-month, Morgan Stanley would pay KeySpan the difference between the market price and $7.57 times 1,800 megawatts (MW). If the market price went below $7.57, KeySpan would pay Morgan Stanley the difference times 1,800 MW. Under the Astoria Hedge, if the market price went above $7.07 per kilowatt-month, Astoria would pay Morgan Stanley the difference times 1,800 MW, but if the market was below $7.07 per kilowatt-month, Morgan Stanley would pay Astoria the difference times 1,800 MW. Over the three-year term of the agreements, Morgan Stanley earned approximately $21.6 million in net revenues.

According to the complaints, the agreements effectively combined the economic interests of KeySpan and Astoria, circumventing the merger review process. The combination incentivised KeySpan to continue to bid the cap, even though much of its capacity would go unsold. This kept the price of capacity high, despite the addition of substantial new generating capacity into the market. Although KeySpan lost actual sales, it made up for the foregone revenues through KeySpan Swap payments from Morgan Stanley, which were backed by the Astoria Hedge. Morgan Stanley's derivatives arrangements effectively insulated KeySpan from the competitive forces in the market, resulting in higher energy prices for New York City consumers.


The DOJ's Section 1 enforcement against KeySpan was generally viewed as an expansion from the traditional enforcement against contracts or combinations between competing market participants to include agreements between parties in different markets when the agreement has the same anti-competitive consequence as a horizontal restraint of trade. The enforcement action against Morgan Stanley takes a significant step further, as it takes action against a firm with a purely financial – rather than physical – interest in the market. The Morgan Stanley enforcement signals an enhanced level of antitrust scrutiny of financial services companies that is targeted at the anti-competitive effects of financial products in physical markets. It raises the question of whether financial players have an affirmative obligation to analyse commodity hedging arrangements for anti-competitive effects.

The KeySpan and Morgan Stanley enforcement actions indicate, at a minimum, that the DOJ considers otherwise permissible(7) financial hedging agreements unlawful if they appear to be devices for circumventing ordinary antitrust review of mergers and acquisitions and result in anti-competitive effects. According to the DOJ, KeySpan's own internal analysis, shared with Morgan Stanley, suggested that an attempt by KeySpan to acquire Astoria's generating capacity would have likely drawn an antitrust challenge. It appears that the KeySpan Swap and Astoria Hedge were developed in response to that analysis.

Since KeySpan did not believe that it could lawfully acquire Astoria, the rationale underlying the DOJ's enforcement action against KeySpan seems to be that a party may not enter into financial hedging arrangements that achieve the competitive effects of a merger of two companies that would not have been permitted under existing antitrust standards. Morgan Stanley executed the KeySpan Swap with knowledge that the offsetting swaps would remove KeySpan's incentive to be price competitive with Astoria, and made the Swap contingent on its own ability to secure an offsetting hedging arrangement. The rationale for the DOJ's enforcement action against Morgan Stanley appears to be that a financial intermediary may not facilitate financial hedging arrangements that achieve anti-competitive effects.

This enforcement action raises several questions:

  • Would Morgan Stanley's role have drawn antitrust sanction if there had been no evidence to indicate that the transactions were designed to accomplish the competitive equivalent of a merger?
  • Does this case signal heightened antitrust scrutiny of financial instruments that indirectly affect competitive behaviour in commodity markets, or is it limited to facts that suggest an intent to evade merger review?
  • What level of antitrust risk is associated with commodity derivatives transactions in which the underlying physical market is highly concentrated?
  • Do pure financial players have a duty to investigate and analyse their commodity hedging arrangements for the competitive effects on the underlying market?


The DOJ has undoubtedly fired a warning shot to the financial services community that the "use of derivatives for anticompetitive ends will not be tolerated", but what remains largely undefined is the extent of the duty that exists for financial services companies with respect to these kinds of commodity hedging arrangement. To manage antitrust risk associated with such transactions, it would be prudent for financial players to put in place due diligence procedures to identify and evaluate competitive effects – if any – of derivatives transactions on physical markets. Such procedures will be particularly important with respect to physical markets characterised by a few significant players.

For further information on this topic please contact Mary Anne Mason or William L Monts III at Hogan Lovells US LLP by telephone (+1 202 637 5600), fax (+1 202 637 5910) or email ([email protected] or [email protected]).


(1) For the DOJ press release please see

(2) Civ Action 11-cv-6875(UA) (September 30 2011). Pursuant to the Antitrust Procedures and Penalties Act, 15 USC Sections 16(b) to 16(h), the DOJ filed its complaint against Morgan Stanley and proposed final judgment, competitive impact statement and stipulation with the Southern District of New York. On October 11 2011 the DOJ published those documents in the Federal Register, thereby commencing a 60-day public comment period. After the comment period, the DOJ is required to respond to any comments and publish the comments and its response. Upon review of the comments and response, the court decides whether the proposed final judgment is in the public interest.

(3) 15 USC Section 1.

(4) See United States v KeySpan Corporation, Civ. Action 10-cv-1415(WHP) (February 22 2010).

(5) KeySpan has since been sold; the state of New York conditioned its approval of the sale on the divesture of KeySpan's Ravenswood generating assets.

(6) For further details please see "Certain financial hedge arrangements can violate Sherman Act".

(7) The KeySpan Swap and the Astoria Hedge did receive Federal Energy Regulatory Commission approval for compliance with its specific agency rules.