On December 17, 2014, as amended December 18, 2014, the Federal Energy Regulatory Commission (FERC) issued an Order to Show Cause and Notice of Proposed Penalty (Show Cause Order)1 directing Houlian (Alan) Chen, HEEP Fund, Inc. (HEEP Fund), CU Fund, Inc. (CU Fund), and Powhatan Energy Fund, LLC (Powhatan) (together, the Respondents) to show cause why they should not be: (1) found to have violated the Federal Power Act and FERC’s regulations prohibiting electric energy market manipulation by engaging in allegedly fraudulent “Up-to Congestion” (UTC) transactions in the energy markets administered by PJM Interconnection, L.L.C. (PJM); and (2) assessed civil penalties and required to disgorge unjust profits totaling more than $34.5 million.
Attached to the Show Cause Order is an 84-page FERC Office of Enforcement (OE) staff report detailing OE’s allegations against the Respondents. OE staff alleges that
Chen, trading on behalf of HEEP Fund and Powhatan . . . , conceived of a fraudulent scheme in connection with the UTC markets operated by PJM; that he communicated the details of that fraudulent scheme to the principals of Powhatan . . . , who knowingly encouraged him to implement it; and that he did implement it on behalf of Powhatan . . . , HEEP Fund, and, later, CU Fund.
Specifically, as we wrote in August 2014, the OE staff report alleges that Chen “devised and implemented a manipulative scheme to inflate trade volumes of UTCs . . . through a series of offsetting wash-like trades designed to wrongfully collect large amounts of market credits known as Marginal Loss Surplus Allocations,” a type of rebate then available from PJM for certain types of trades. OE staff further alleges that, “with Powhatan’s knowledge and encouragement,” Chen cheated the market by “plac[ing] UTC trades in opposite directions on the same paths, in the same volumes, during the same hours for the purpose of creating the illusion of bona fide UTC trading and thereby to capture large amounts of” Marginal Loss Surplus Allocations. This “round-trip” trading strategy, OE staff alleges, is functionally equivalent to prohibited wash trading and similar to the infamous “Death Star” circular scheduling scheme some traders engaged in before and during the Western Energy Crisis of 2000-2001.
FERC states that its issuance of the Show Cause Order “does not indicate [FERC] adoption or endorsement of the OE Staff Report.” In addition, seeking to correct what he describes as a “common misconception about one element of [FERC’s] enforcement process,” Commissioner Philip D. Moeller issued a statement on December 18, 2014, which he read into the record of FERC’s open meeting on that date, emphasizing FERC’s “long-standing practice not to pre-judge the findings made in staff reports” and that FERC “will consider the entire record . . . to determine whether the assessment of civil penalties is appropriate.”2
Chen and Powhatan, through the FERC vs. Powhatan Energy Fund, LLC website, which includes video testimonials from a variety of independent energy industry experts, continue to maintain that the trading activity at issue did not constitute market manipulation but was legitimate statistical arbitrage under the PJM market rules in effect at the time. The Show Cause Order sets off what likely will be a contentious proceeding at FERC—and perhaps later in court—as Kevin Gates, one of Powhatan’s co-owners, has stated that he would “rather go bankrupt than settle.”3 The deadline for the Respondents to answer the Show Cause Order is February 2, 2015.4 OE staff will have 30 days to reply to the answer(s) when filed.
New FERC Commissioner Norman C. Bay, who was the director of OE when the underlying investigation of UTC transactions in PJM began, recused himself in October 2014 and, accordingly, did not vote on and will not participate in the proceeding following the Show Cause Order.