Several Wall Street firms have made headlines in recent months for their knock-down battles with a federal regulatory agency. The agency in these cases, though, is not the Securities Exchange Commission (“SEC”) or the Federal Reserve or another banking regulator. It is instead the Federal Energy Regulatory Commission (“FERC”), an agency better known for monitoring pipeline construction than for regulating a trade floor. Armed with expanded statutory authority, an enforcement budget increased by more than double, and corresponding increases in staff, FERC has filed or is considering filing civil charges against three large Wall Street banks—JPMorgan Chase, Deutsche Bank and Barclays Bank PLC—alleging that bank employees with each firm engaged in complex strategies to manipulate the prices of traded electricity products.

The fact that these entities have come to the attention of FERC’s Office of Enforcement (“Enforcement”) is not entirely surprising. All three banks have energy trading shops that have appeared in the electricity trading league tables in recent years, along with divisions of other banks such as Morgan Stanley, BNP Paribas, Citigroup and J. Aron. The relative size of fines being proposed by the FERC staff, however, and the vigorous defenses being pursued in the respective proceedings, set these investigations apart from previous FERC investigations.

For example, in the most recent allegations to be made public,1 FERC Enforcement is seeking from Barclays payment of penalties and disgorgement totaling almost half a billion dollars, a total that exceeds collections (penalties and disgorgement) for all settlements entered into by FERC Enforcement in the six fiscal years since enactment of FERC’s enhanced investigation power combined.2 The proposed fine to Barclays comprises $34.9 million (plus interest) in disgorgement plus $453 million in penalties to be paid by Barclays ($435 million) and four Barclays employees. In recommending this unprecedented penalty, Enforcement staff asserted that Barclays’ recently-announced agreement reached with the Commodity Futures Trading Commission, the Department of Justice and the U.K.’s Financial Services Authority to pay $453 million to settle claims that Barclays manipulated the London Interbank Offer Rate (Libor) evidences a pattern of manipulative activity across the company.3

In written responses to the FERC show cause order, Barclays argues that the identified trading behavior was economically sound and served legitimate business purposes, that the company lacked market power (as found by FERC in prior orders) necessary to move prices, and that the FERC Enforcement report did not provide adequate support for the manipulation charges. The company also notified the FERC that it would elect to accept an immediate penalty assessment so that it could have the case adjudicated de novo by a federal district court under Section 31(d)(3) of the Federal Power Act,4 instead of an administrative hearing before a FERC Administrative Law Judge. If the FERC assesses penalties and Barclays proceeds to district court review, it will mark the first time this option has been exercised by the subject of a FERC Enforcement investigation.5

FERC’s Enhanced Manipulation Authority Fuels Increased Activity

The actions taken against banks are part of a trend of sharply increased activity by FERC Enforcement since passage of the Energy Policy Act of 2005 (“EPAct 2005”).6 EPAct 2005 provided FERC with expanded statutory authority to conduct investigations and enforce its rules, and has been complemented with substantial increases in FERC’s budget to support hiring new personnel, including a whole new oversight and analytics team and numerous investigators with experience as prosecutors or working for the FBI.

FERC’s new investigators and analysts bring with them a new enthusiasm for rooting out misconduct, but in almost all cases, they come to FERC with little or no understanding of the peculiarities of the energy trading markets in the United States. The electricity and natural gas trading markets, and especially the physical products traded in the markets regulated by FERC, are quite immature compared to the stock market or to markets for trading agricultural futures. In addition, traded energy products have unique characteristics, such as the relative prevalence of physical deliverability requirements and the lack of storability for electricity. For these reasons, some of the analytical tools typical of past government enforcement actions do not translate well to the FERC regulated markets.

For example, in enacting EPAct 2005, Congress borrowed language from the SEC’s primary enforcement tool, Section 10b-5,7 instructing FERC to enact new regulations to investigate and penalize use of “any manipulative or deceptive device or contrivance” in connection with the purchase or sale of electric energy or natural gas. Accordingly, FERC adopted the following implementing regulation:

It shall be unlawful for an entity, directly or indirectly, in connection with the purchase or sale of natural gas [or electric energy] or the purchase or sale of transportation services subject to the jurisdiction of the [FERC], (1) to use or employ any device, scheme, or artifice to defraud; (2) to 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 light of the circumstances under which they were made, not misleading, or; (3) to engage in any act, practice, or course of business that operates or would operate as a fraud or deceit upon any entity.8

FERC’s new manipulation provision uses the language of 10b-5 and the FERC has said that it will consider SEC precedent for enforcement of 10b-5, but the concepts are not easily transferable. Consider a common SEC enforcement action for manipulation under 10b-5 alleging incomplete, inaccurate or incorrect statements in written submissions such as a prospectus or S-1—documents on which investors typically rely when deciding whether to invest in the opportunity presented by the submitting company. In a bid-offer energy market, where the buyer’s and seller’s identities frequently are not known to one another, there is not a comparable risk of reliance on misrepresentations or omissions. This distinction is even more apparent in the centralized physical electricity markets operated by Regional Transmission Organizations (“RTOs”) or Independent System Operators (“ISOs”). In these markets, the RTO or ISO typically receives and aggregates bids and offers from numerous parties, then identifies the point of intersection which establishes a single market-clearing price that all sellers are paid.

FERC Theories of Market Manipulation

In the absence of obvious 10b-5 manipulation precedent, FERC Enforcement is crafting its own, new theories for how energy traders might manipulate FERC-regulated energy markets.

The theory employed in the Barclays case provides a good example of FERC Enforcement’s approach. In this case, FERC Enforcement alleges that Barclays manipulated FERC-regulated energy markets by engaging in loss-generating trading of a short-term product (next-day, fixed-price, physical electricity sold on the IntercontinentalExchange (“ICE”)) to benefit a position held in another energy product market (financial swap positions at the primary electricity trading points in the Western United States). The price of the secondary product, for the theorized manipulation to be successful, must be linked to or somehow affected by the price of the first product. Put another way, FERC Enforcement alleges that Barclays’ power traders agreed among themselves to engage in a pattern of trading to lose money on day-ahead trades with the intent of affecting the final daily weighted average price of those trades executed on ICE by moving the overall product index in a direction that would enhance the value of Barclays’ financial swap positions.

The same theory was applied in FERC Enforcement’s investigation of Constellation Energy Commodities Group (“CCG”), which was settled in March 2012 for a penalty of $135 million and disgorgement of $110 million—by far FERC’s largest dollar value enforcement action to date.9 In CCG’s case, FERC Enforcement alleged that the company violated FERC’s anti-manipulation regulation by entering into virtual transactions and day-ahead physical schedules without regard for their profitability, but with the intent of impacting day-ahead prices in the New York ISO and ISO New England to benefit certain financial contract for differences (“CFD”) positions that CCG held. In the resulting settlement, CCG neither admitted nor denied the allegations of manipulation.

FERC has not yet made any public charges of market manipulation against JPMorgan. The New York Times reported in May 2013, though, that it had reviewed a 70-page confidential report drafted by FERC Enforcement, arguing that JPMorgan devised “manipulative schemes” that transformed “money-losing power plants into powerful profit centers.” The document also reportedly takes aim at Blythe Masters, a top bank executive, for her supposed “knowledge and approval of schemes” and for “falsely” denying under oath such knowledge, and alleges that the bank “planned and executed a systematic cover-up” of documents that would have exposed the strategy. JPMorgan has publicly disputed the report’s claims, arguing that the company’s trading was transparent and compliant with applicable rules and stating its intent to vigorously defend the bank and its employees.

Prior to the recent investigations of large banks, the numerous manipulation investigations settled by FERC Enforcement have almost all involved entities whose primary business is energy-related. These companies have continuing relationships with FERC as their primary regulator. In most cases, a substantial portion of the companies’ revenue is tied to conduct that is regulated directly by FERC, and FERC actions have the potential to play a major role in the viability of the companies’ future operations. As a result, FERC is often in a position of relative strength when investigating alleged market misconduct.

The banks, on the other hand, do not view FERC as their primary regulator, and their energy trading operations are not essential to business. In addition, the banks have a different, arguably more seasoned, perspective on trading generally, having been participants in other trading markets that predate energy markets by many years. For these reasons, it is not surprising that the first significant challenges we are seeing to FERC’s expanded authority to prosecute manipulation in energy markets and FERC’s expanded and eager Enforcement team are coming not from energy companies, but from banks.

Potential for Criminal Action as a Result of FERC Investigation

What remains to be seen is how the FERC will respond to the banks’ challenges. Thus far, FERC has not made any public referrals to the Department of Justice for criminal prosecution in connection with its market investigations. FERC practitioners anticipate that these referrals are coming, though, and that the most likely basis for criminal referrals will be allegations of criminal misconduct in the course of the agency’s investigations, such as false statements or obstruction. The recent rhetoric in the JPMorgan case, with its allegations of false representations and cover-up schemes, certainly seems consistent with this prediction. The threat of criminal prosecution is heightened by the duration of FERC’s investigations; the Barclays investigation, for example, was initiated in 2007, as was the CCG investigation settled in 2012. And, despite having issued a show cause order in October 2012 outlining the anticipated allegations against the bank and its traders, FERC Enforcement continues to subpoena further materials and testimony from Barclays and related witnesses.10

* * *

FERC’s Enforcement division has been putting to wide use the agency’s expanded investigatory authority, engaging in protracted investigations and developing new theories for how market manipulation may be attempted in the U.S. energy markets. There is not universal acceptance of these new theories, though, and there is particularly strong resistance to FERC Enforcement’s theory of cross-market manipulation. Subjects of FERC investigations and industry participants alike are asking how trades in an open market, where the only communication of any sort is the submission of binding bids and offers, can violate FERC’s new, fraud-based statutory prohibition on market manipulation. These enforcement efforts on the part of the FERC may soon see an initial test in the form of either de novo court review or referrals to the Department of Justice. Many companies on Wall Street and in energy centers like Houston alike are anxiously watching to see this debate over the FERC’s anti-manipulation authority play out in the courts.