On February 28, 2014, Powhatan Energy Fund (“Powhatan”) launched a public website disclosing that for more than three years, the Federal Energy Regulatory Commission (“FERC”) Office of Enforcement (“OE”) has been investigating Powhatan for alleged manipulation of the PJM Interconnection (“PJM”) energy market.
According to FERC OE’s preliminary findings, Dr. Houlian Chen (“Chen”), trading on behalf of Powhatan, himself and other clients, manipulated PJM’s energy market by taking advantage of an alleged market loophole that permitted payments despite unprofitable Up To Congestion (“UTC”) transactions. Powhatan has countered that FERC’s investigation violates due process because prior to FERC OE’s investigation, there was no FERC order or express regulation to put Powhatan on notice that the trades were unlawful. Furthermore, Powhatan maintains that it entered into the UTC transactions in an open, transparent manner without concealment or misrepresentation, and that it is not manipulative to take advantage of market flaws. Only much later did FERC change the complicated rules to close the supposed loophole.
Substantively, this is an important test of FERC’s scienter requirement for manipulation claims and whether market participants have a duty to report or otherwise not act on market design flaws. This process may result in more mixed signals regarding what market participants may or may not do when following the existing rules.
Although the investigation is still ongoing, it is noteworthy because it is the first time in recent history that, while pursuing its defense as part of the non-public investigative process, a company is actively trying its case in the court of public opinion. Powhatan has disclosed FERC OE’s document preservation directive, data requests and Powhatan’s responses, and FERC OE’s preliminary findings and Powhatan’s response. The standard investigation process includes FERC’s launch of a non-public investigation, non-public release of OE’s preliminary findings, and settlement discussions or recommendations to the Commission for an administrative proceeding or civil action. Usually, FERC’s non-public investigations only become public after OE’s inquiry has progressed to a later stage and settlement agreements are approved or when FERC issues publically a Notice to Show Cause or Notice of Alleged Violation.
Powhatan’s public website has disrupted the “usual process.” This investigation of Powhatan remains open and OE is still deliberating internally on whether to issue an Order to Show Cause or otherwise proceed with a formal investigation including subpoena power, an administrative proceeding or other civil action. As of May 5, 2014, no Order to Show Cause or Notice of Alleged Violation has been issued.
In a recent interview, the managers of the fund said "the government wields tremendous power when they swing around the charge of market manipulation" and going public "was an insurance policy against our personal and professional reputations".i Indeed, according to recent press reports, the hedge fund has “embarked on a public campaign” to stop Norman Bay, the current FERC Enforcement director and former prosecutor from being confirmed as the next chairman of the FERC.
And the Allegation Is...
FERC alleges in its preliminary findings that between February 2010 to August 2010 Chen manipulated the PJM market by matching UTC transactions with transmission reservations to collect Marginal Loss Surplus Allocation (“MLSA”) payments “with the intent to avoid the effects of price changes in the market.”ii A UTC transaction is “a virtual transaction that earns or loses money on the change between the Day-Ahead Market (“DAM”) and the Real-Time Market (“RTM”) of the spread in prices between two price nodes in PJM’s system.”iii
Until September 2010, every trader who scheduled a UTC transaction was first required to reserve the transmission hours necessary for the intended UTC scheduled transaction. Each confirmed reservation would receive a transmission reservation ID, and the trader would use this reservation ID to place bids on the UTC transaction.iv Traders would incur several costs from scheduling UTC transactions including reservation costs and ancillary costs for market support, market monitoring, and secondary control center assessments. Reservation costs averaged $0.17 per megawatt-hour (“MWh”) and ancillary costs varied from $0.03 to $0.05 per MWh.v
PJM applies the marginal loss method to transmission line loss charges which are included in the per MWh price of electricity in PJM’s electricity market. According to PJM’s September 2009 tariff schedule, “MWhs of successfully scheduled trades associated with paid-for transmission in a given hour received a proportionate share of the surplus collected throughout the entire PJM market for the hour” and MLSA refers to this payment distribution.vi On September 17, 2009, PJM decided to pay retroactively MLSA distributions for the prior 15 month period and reflected those payments on the settlement statements from November 2009 to February 2010. All eligible MWhs, including eligible UTC transactions, received MLSA payments; and PJM distributed the surplus transmission line loss collections among all eligible MWhs irrespective of the transmission service type or service cost differences.vii
According to FERC OE’s preliminary findings, Chen identified node pairs where “changes in the price spread between the DAM and RTM consistently produced a de minimis profit or loss, or created wash-like or sham pairs of transactions with price spread changes that netted to a zero or near-zero profit or loss.”viii In other words, according to OE, Chen designed and used “UTC transactions scheduled against transmission reservations as a vehicle to receive MLSA.” ix
FERC OE estimates that during February 2010 to August 2010 Chen made more than 18 million MWh of transmission reservations associated with 19.5 million MWh of UTC transactions and nearly 10 million MWh were eligible to receive the MLSA payments.x As a result of Chen’s trading activity, the trades lost more than $6.7 million, but earned almost $11.5 million in MLSA payments, resulting in approximately $4.8 million in total net profit.xi
Market Design Flaws and Market Manipulation
FERC prohibits entities from directly or indirectly using or employing any device, scheme, or artifice to defraud or engaging in any act, practice or source of business that operates or would operate as fraud or deceit upon any entity in connection with the purchase or sale of electric energy or purchase or sale of transmission services subject to FERC’s jurisdiction.xii Market manipulation is established by evidence that satisfies all three elements of a market manipulation claim: (1) use of a fraudulent scheme, device, or artifice or material misrepresentation; (2) with the requisite scienter; (3) in connection with the purchase or sale of electric energy or the transmission of electric energy subject to FERC’s jurisdiction.xiii
Both Powhatan and FERC OE appear to agree that element three is satisfied, because PJM is a FERC-approved regional transmission organization and an independent systems operator and Chen’s UTC transactions and trades occurred within PJM’s market. However, Powhatan rejects FERC OE’s contention that Chen’s trades involved a fraudulent scheme or material misrepresentation and were undertaken with the requisite scienter to manipulate the market.
FERC OE relies on the Securities and Exchange Commission (“SEC”) case In re Amanat, in which the Third Circuit affirmed that “manipulation may exist under Regulation 10b-5 where trades are sham trades designed to avoid the effects of price changes due to market forces.”xiv According to OE Staff’s reasoning, Chen’s UTC trading activity was not designed to make money according to market dynamics, instead the UTC trades were designed to gain profit through the large volumes of eligible MWh that received MLSA payments.xv Furthermore, according to OE, Chen’s trading UTC trading activity was “uneconomic” and thus violating FERC’s anti-manipulation rules. xvi
Powhatan counters that Chen’s UTC transactions were legitimate transactions that were authorized by PJM’s tariff design and market activity. Powhatan also cites instances where Chen lost money on certain UTC transactions, when the prices did not move in a manner that he had anticipated. Importantly, Powhatan argues that there is a fundamental difference between illegally engaging in market manipulation and legally taking advantage of a defective market design. According to Powhatan, Chen’s trades may have benefitted from a defect in PJM’s market design, but Chen’s trades violated no law, because they involved no fraud or fraudulent intent.
FERC OE claims that Powhatan defenses are without merit because in other cases, OE Staff asserted and FERC accepted that “improper intent alone may transform what appears to be a legitimate market transaction into prohibited manipulation.”[xvii] In addition, FERC OE relies on other FERC cases and settlements in which market participants who acted contrary to their economic interests fell within the zone of manipulative activity.
FERC OE contends that evidence establishes the scienter essential to alleging market manipulation in this investigation. During his deposition, according to the released documents, Chen testified that he selected PJM nodes with similar historic price movements in order to limit the spread risk between the DAM and RTM.xviii After Chen and Powhatan founders realized the profitability of Chen’s trading strategy, they created the Powhatan fund specifically to benefit from PJM’s market design flaw. In fact, Chen and Powhatan’s trades increased exponentially from 4 to 20. In separate testimony, according to the released documents, one of Powhatan partner’s also acknowledged that the only risk in Chen’s UTC trades was “a new risk that the [MLSA] revenues would exceed the costs associated with the trades.”xix According to OE, a Powhatan partner advised a relevant party to keep the UTC transactions “strictly confidential” since “just knowing about this inefficiency is our only edge.”xx
Powhatan argues that Chen and the company did not intend to manipulate PJM’s electricity market but rather benefit from PJM’s flaw in its tariff’s design. In fact, PJM has since changed the tariff design to exclude UTC transactions from receiving MLSA payments. Powhatan also compares Chen’s UTC trading activity to high-frequency trading activities permitted by the SEC. Powhatan insists that FERC OE Staff is violating its due process rights since neither Chen nor Powhatan were on notice that the collection of MLSA payments from UTC transactions violated FERC rules, because the payments were fully sanctioned by PJM.
FERC OE apparently dismisses Chen and Powhatan’s defenses concerning scienter for two reasons. First, deposition testimony and other evidence corroborates OE Staff’s conclusion that Chen’s UTC trading activity were not subject to genuine market risks, because by matching the node pairs (A to B and B to A), Chen brought the risk spread to zero or almost zero.xxi In fact, during the relevant trading period, according to OE Staff, Chen and Powhatan expressed concern that the MLSA payments may be incorrect and that one possibility would be that there would be in “big trouble” or have to retroactively repay some of the payments.xxii Finally, OE Staff emphasizes that the MLSA proceedings and FERC’s statement in Black Oak Energyclearly stated that the FERC wanted to avoid a market rule in which “arbitrageurs can profit from the volume of their trades.”xxiii
Current State of Play
Before Powhatan’s disclosure of FERC’s non-public investigation, Powhatan attorneys notified FERC that Powhatan would release the information via a website. In response to the warning, FERC OE stated that “it is unaffected by the outcome” of Powhatan’s plan to release publicly the information and cited to FERC procedure regarding the issuance of a Notice of Alleged Violation. The website http://www.ferclitigation.com contains a summary of the exchanges between FERC and Powhatan’s legal representatives, position papers from 12 independent experts, and Powhatan’s claim that FERC OE Staff has unfairly targeted the company.
Although the investigation is far from over, it is clear that Powhatan’s own public disclosure of FERC OE’s non-public investigation puts FERC and the OE Staff on notice that it is no longer “business as usual” in response to alleged violations.