On November 21, 2019, the Federal Energy Regulatory Commission, FERC, published its 2019 Report on Enforcement.1 In the Report, the Office of Enforcement of the FERC informs the public and the regulated community of Enforcement’s activities during the 2019 fiscal year, including an overview, and statistics, of the four divisions within Enforcement: Division of Investigations (DOI), Divisions of Audit and Accounting (DAA), Division of Analytics and Surveillance (DAS) and the Division of Energy Market Oversight (DEMO).2
The DAA administers FERC’s audit and accounting programs to ensure compliance, accountability and transparency. The DOI conducts both public and non-public investigations of any possible FERC compliance violations.
DAA audits represent the proactive function of FERC’s Office of Enforcement. DAA’s mission is to perform financial and operational audits of industry participants to ensure compliance with the FERC’s rules, orders, regulations and statutes. DAA provides interpretive guidance concerning the FERC’s rules and advises the FERC on compliance issues. Audits are fundamentally different from investigations as the purpose of audits is not to find wrongdoing, but rather to oversee and improve compliance.
This difference in focus is key to understand in preparing for a FERC audit. If non-compliance is found during an audit, the audit staff will recommend corrective actions to bring the company back into compliance. After an audit, the FERC will issue an audit report identifying areas of non-compliance and corrective actions required of the Company. Nevertheless, the FERC audit staff will refer matters to the DOI when audits uncover suspected violations that appear to warrant investigation. It is important to remember that FERC expects cooperation with audit staff and that, in the event that a violation were to be found, the Commission will apply a credit against possible penalties in the event of exemplary cooperation, so it is in the company’s interest to cooperate with audit staff.
In 2019, the DAA completed 11 audits of public utility and natural gas companies covering a variety of topics. The audits resulted in 76 findings of noncompliance, 286 recommendations for corrective action, the majority of which had to be implemented within six (6) months, and directed $161.2 million in refunds and other recoveries.
The DAA and other enforcement divisions of the regulators in the commodities marketing and trading industry expect firms to have robust record retention programs.
Record retention rules for United States commodities marketing and trading firms
Record retention for US commodities marketing and trading firms is extremely important. From a practical perspective, commodities marketing and trading firms generate a significant amount of records. There is a cost associated with retaining such a significant amount of records, and a closely followed record retention program reduces such practical and operational costs. A record retention program is also important to commodities marketing and trading firms because the cost of non-compliance with applicable regulations could result in hefty fines and/or reputational damage. Additionally, because US regulators have authority to audit and/or request to examine commodities marketing and trading companies’ records, maintaining unnecessary records increases a company’s liability in litigation and regulatory. This increased liability is also an increased cost to the company in the form of costs associated with attorneys, damages, fines and compliance.
In this article we explore a hypothetical situation in which a natural gas marketing and trading company receives a FERC audit commencement letter. The example highlights the complexities surrounding whether or not the company is required to self-report to the FERC possible violations of a company’s regulatory obligations. This complex situation can be exacerbated by the company’s failure to create and/or maintain the FERC-required documentation.
The scenario below provides a practical example of a natural gas marketing and trading company that receives a FERC audit commencement letter. Additionally, the example highlights the complexities surrounding whether or not the company is required to self-report to the FERC possible violations of a company’s regulatory obligations. This complex situation is compounded by the company’s failure to create and/or maintain the FERC required documentation.
Large E&P Company (E&P) plans to expand its business from simply marketing its production to trading, optimizing its assets in, and information of, the natural gas market. To do so, E&P creates a separate trading company, Trading, Inc. (TI), incorporated in Delaware.
E&P instructs its Contracts Manager, Connie, to facilitate the transition of the “downstream gas assets” to TI. Connie writes and sends a generic assignment letter that contains all of the gathering agreements, firm transportation, interruptible transportation and processing arrangements that she finds listed on different spreadsheets. Connie receives a few acceptance letters in response to her assignment letter and uploads these acceptance letters into an electronic file that she has created on her computer.
Connie is told by E&P management that she must be done with the transition by December 31, 2016. On December 30, 2016, Connie deems the transition complete and verbally instructs the Human Resources department to designate the E&P Schedulers and E&P Marketers as TI employees on January 1, 2017. No changes were made to the employment contracts and the employment contracts are maintained in a Human Resources system owned by the E&P company.
Effective January 1, 2017, TI executes a NAESB agreement with E&P to buy “all” of E&P production of natural gas at the “well head.” E&P does not execute the NAESB agreement. Connie places the NAESB signed only by TI in the TI folder located on her desk.
The Schedulers and Marketers continue to do their job as they always have (a) logging into pipeline bulletin boards as E&P and moving natural gas on a combination of E&P and TI transportation contracts and (b) calling counterparties to sell natural gas, introducing themselves as E&P employees.
The individual purchases and sales of natural gas between E&P and TI is never confirmed. There is no documentation of the individual purchases and sales between E&P and TI.
The TI Invoicing department pays bills as usual even though some of the pipeline statements and invoices are in the name of E&P. To be sure that only TI’s expenses are on TI’s books, the Invoicing Department Manager, Iva, instructs the Schedulers and Marketers to call their counterparties and tell them that E&P has had a name change to TI. Until it is fixed, Iva creates something called a “bill-back” to remove the expenses from TI’s book, sending the bills back to E&P. These bills are shredded 10 days after they are paid and no electronic copies are maintained.
This activity continues for approximately two years.
Because TI does not have a Legal or Compliance department, on June 2019, TI’s receptionist receives an audit commencement letter from the FERC.
TI being a company incorporated in Delaware, purchasing and selling natural gas and moving natural gas under natural gas transportation in the United States interstate markets, TI is subject to FERC jurisdiction as a customer of an interstate natural gas pipeline who makes purchase and sales over a certain threshold who is required to file a Form 552 report. Therefore, the FERC auditors may request TI to comply with its audit requests. TI should take this audit request seriously.
TI’s receptionist should immediately make TI Management and employees aware of the FERC audit request. Since TI does not have a Legal or Compliance department, it may consider hiring outside counsel. Although, at this point, hiring outside counsel may be premature. At the very least, TI needs to appoint a “project manager” to manage the preparation of a response to the FERC Audit, which includes: preparing employees that will be participating, arranging workspace, analyzing IT needs and creating a work schedule. To prepare the participating employees, Connie must make sure each of them is:
- Aware of the audit staff’s planned agenda
- On time and available to join other sessions
- Generally familiar with the materials submitted to the auditors, but thoroughly familiar with the materials related to his/her particular area of responsibility
- Prepared with documents and information readily accessible
- Respectful and not defensive
- Not guessing at answers and being truthful when he/she does not know the answer;
- Not providing extraneous information and
- Taught not to automatically agree if” FERC points out an example of non-compliance, but to agree to look into the matter.
To prepare for the FERC audit, Connie speaks with Iva. Iva tells Connie that she has instructed the Marketers and Schedulers to call counterparties and tell them that E&P has changed its name to TI. Although, Connie is not a lawyer, she knows that this is not correct. As a Contract Manager, she knows that TI is a separate legal entity.
Connie believes that there is a legal issue and raises the issue to E&P’s Legal department.
E&P’s Legal department begins to investigate.
The current lawyers in E&P’s Legal department discover that when E&P decided to create a separate trading company, TI, that it did not engage the internal Legal department or any outside counsel. Therefore, and in order to help facilitate a response to FERC audit, E&P’s Legal department starts a due diligence process.
The definition of “downstream gas assets” is unclear. Neither Connie nor anyone in the TI business can explain exactly what encompasses all the “downstream gas assets.” This is problematic because natural gas that is transported in US interstate commerce is subject to FERC Shipper-Must-Have-Title rules.
The FERC Shipper-Must-Have Title rule provides that when natural gas is transported on interstate pipelines the party holding the pipeline capacity must also hold title to the gas being transported. Additionally, and coupled with the FERC Shipper-Must-Have-Title rule is the Buy-Sell Prohibition. The Buy-Sell Prohibition provides that a gas owner may not sell its gas to a capacity holder at one point on a pipeline only to buy that same gas back at another point on the pipeline. The Shipper-Must-Have-Title Rule and Buy-Sell Prohibition ensure that pipeline capacity is released properly, transparently and for the correct value.
It is extremely important that gas that is purchased by TI from E&P is moved from point A to point B on transportation that is in the name of TI. TI, Connie, should have clarified the meaning of “downstream gas assets” and made sure that she was aware of all the pieces of gathering, transportation and processing that would be moving TI’s natural gas from point A to point B. In addition to these problems surrounding title transfer point, there is a record creation and retention problem created by TI and E&P not having a fulling executed NASEB and corresponding confirmations for each purchase and sale.
The generic assignment letter is also problematic. Some gathering and transportation is not assignable, whether it is because the agreement may only be assigned to affiliates or whether the agreement is only assignable to an entity that dedicates production to the gathering line, transportation pipeline or processing facility. Connie did not ensure, by reading the gathering, transportation and processing contracts, that these agreements were actually assignable. Therefore, some of the agreements were not transferred to TI, which also raises FERC Shipper-Must-Have-Title concerns for both TI and E&P.
The receipt of only a few acceptance letters to the assignment, also present TI with document retention concerns.
FERC’s record retention requirements are intended to strengthen FERC’s ability to monitor and enforce its substantive rules and policies and to enhance market transparency. FERC requires that one or more individual be designated with official responsibility over the records retention program and that companies such as E&P and TI retain for a set period of time all data and information for which they billed prices for natural gas and retain all contracts for the purchase or sale of natural gas.
Although it is not illegal to purchase “all” of E&P’s production, there is a problem with designating the delivery area as the “well head.” There is no such thing, exactly, as the “well head.” The NAESB should have contained a delivery and title transfer point of a certain pipeline meter point or other location. Because no actual title transfer point was ever written into the contract and/or ever confirmed, TI could not determine at what point did it purchase the natural gas from E&P. Again, this raises Shipper-Must-Have-Title concerns for TI and E&P.
It is a cause for concern that the Schedulers, who are TI employees on January 1, 2107, continue to use log-in names for pipeline bulletin boards that belong to E&P after this date. It is also concerning that the Schedulers continue to schedule natural gas on these pipeline bulletin boards using transportation contracts that belong to E&P. It is equally concerning that Marketers, who are also TI employees on January 1, 2017, would continue to call the same customers and introduce themselves as “Marketer from E&P” after this date. These sorts of things should have been red flags to these TI employees. TI’s lack of awareness for red flags is probably attributable to TI’s lack of its own Legal and/or Compliance department. It is also an issue that the employment contracts were not updated to reflect the change of employment to TI.
Further, the TI Invoicing department should not have been paying bills that it received in the name of E&P. In the normal course of business, one company does not pay the bills of another company. There could be a situation where one company provides bill payment services to another company for a fee, but that does not seem to be the case in this scenario. Again, invoices coming to the TI address in the name of E&P should have been a red flag to the TI Invoicing department’s employees. Invoices also cannot be shredded inside of the FERC regulatory record retention period. The shredding of the invoices could create a regulatory infraction and perhaps another instance where self-reporting is required.
Iva should not have given instructions to Marketers and Traders to call their counterparties to tell them that E&P had changed its name. From a legal perspective, E&P did not change its name. E&P still existed. TI was a new and completely separate entity. TI’s lack of its own legal and/or compliance department probably led to this problem. A company with a legal and/or compliance resource could ask questions when faced with these situations.
Iva’s creation of an accounting mechanism to remove costs from TI’s books is another red flag. In this situation, E&P’s Invoicing department should have raised the red flag to its Legal department. Although not covered in this writeup, this may also raise accounting concerns. Throughout this due diligence process, E&P Legal department discovers that the above activities have continued for approximately two years.
The FERC’s civil penalty authority covers violations of the Natural Gas Act NGA or any rule, regulation, restriction, condition, or order made or imposed by the FERC under its NGA authority. FERC has civil penalty authority of in excess of $1 million per day per violation.
Given this penalty authority and the duration of this potentially illegal activity, E&P Legal department determines that both TI and E&P must self-report violations of the Shipper-Must-Have-Title Rule to FERC. In preparing the Self-Report, the Legal department should take immediate steps to correct the violation and indicate in its Self-Report the corrections implemented and the steps that the company has taken to ensure that it will not have compliance issues in the future, such as adopting a compliance plan and performing compliance training.
The FERC Penalty Guidelines apply a set of mitigating and aggravating factors which can increase or decrease civil penalty amounts. The mitigating factors include whether or not the company implemented a robust compliance program that demonstrates a culture of compliance and whether the company self-reported the violation. Aggravating factors that can increase penalties include prior violations and involvement of management and presence of a compliance program. Applying these guidelines, TI and/or E&P’s civil penalty may be reduced by the fact that this was TI’s and E&P’s first violation of this kind and a complete self-report of the facts. TI and E&P should also implement a compliance program and take steps to demonstrate a culture of compliance.
An earlier version of this article appeared on Law360 on March 2, 2020.