48013751 ferc’s new rule prohibiting fraud, deception and misleading statements presented by:...

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FERC’S NEW RULEPROHIBITING FRAUD, DECEPTION AND

MISLEADING STATEMENTS

Presented by: Debbie SwanstromPatton Boggs LLP

American Public Power Association 2006 National ConferenceChicago, Illinois

For further information, please contact Debbie at (202) 457-6565 ordswanstrom@pattonboggs.com

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OverviewThis presentation includes:

• an explanation of the scope and underlying purpose of FERC’s new rule;

• a description of the penalties that might be imposed for violations of FERC’s rule;

• an overview of trading practices that would and would not violate FERC’s rule; and

• a summary of FERC’s Enforcement Policy Statement illustrating the importance of compliance training, internal audits and self-reporting.

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It shall be unlawful for any entity directly or indirectly, in connection with the purchase or sale of electric energy or natural gas or the purchase or sale of transmission or transportation services subject to the jurisdiction of the Commission:(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 the 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.

FERC’s New Rule

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Goal of FERC’s Rule

• The goal of the rule is to “deter or punish fraud in wholesale energy markets” regulated by FERC.

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FERC’s Definition of Fraud

• FERC generally defines “fraud” to include “any action, transaction, or conspiracy for the purpose of impairing, obstructing or defeating a well-functioning market.”

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Scope of FERC’s Rule

• FERC’s new rule applies broadly to “any entity,” including governmental utilities and other market participants that are not traditionally jurisdictional.

• However, the rule is limited to FERC jurisdictional transactions and excludes activities such as retail sales which are outside of FERC’s jurisdiction.

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Nexus Requirement

• There must be a nexus between the fraudulent conduct and a jurisdictional transaction.

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ISO/RTO Example

• According to FERC’s interpretation of the new rule, “any entity engaging in a non-jurisdictional transaction through a Commission-regulated RTO/ISO market that acts with intent or with recklessness to affect the single auction clearing price (which sets the price for both jurisdictional and non-jurisdictional entities) would be engaging in fraudulent conduct in connection witha jurisdictional transaction . . . .”

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Penalties for Violations of FERC’s Rule

• A civil penalty of up to $1 million a day potentially could be imposed for each violation of FERC’s rule.

• Criminal penalties also potentially could be imposed. A person who violates FERC’s rule is subject to imprisonment for a term of not more than 5 years and a fine of not more than $1 million.

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• FERC has indicated that it plans to apply penalties to governmental utilities. Arguably, however, the penalty provisions of EPAct do not apply to governmental utilities because they do not fall within the definition of a “person.”

• The penalty provisions potentially could be applied by FERC to individual officers or employees of governmental utilities.

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Other FERC Remedies

• FERC potentially may impose additional remedies, such as:

– disgorgement of unjust profits;– conditioning, suspending, or revoking

market-based rate authority; or – revoking safe harbor status of governmental

utilities’ reciprocity transmission tariffs.

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Scienter• Before a person can be found guilty of

violating FERC’s rule, there must be a showing of “scienter.”

• Scienter has been interpreted to include knowing, intentional or reckless misconduct.

• Inadvertent errors would not violate FERC’s rule.

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• FERC likely will look for evidence of scienter in voice recordings of trader calls, instant messages, emails, meeting minutes or trader logs.

• Scienter also might be inferred through unusual patterns of trading or withholding and outage behavior.

• This is particularly true in an organized ISO/RTO market where trading patterns may be noticed by market monitors.

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Disclosures • The new rule does not create an affirmative duty

to disclose any information that is not otherwise required to be disclosed pursuant to a separate law, order, rule or tariff.

• But if an entity, either voluntarily or through a separate legal requirement, does provide information and it misrepresents or omits a material fact such that information provided is “materially misleading” this can be a violation of the rule.

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Materiality

• A fact is material if there is a substantial likelihood that a reasonable market participant would consider it in making its decision to transact because the fact significantly altered the total mix of information available.

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Examples of Potential Material Information

• Transmission information FERC requires to be posted on an OASIS, such as TTC or ATC calculations, likely will be deemed material.

• Information used to settle an organized ISO/RTO market clearing price also likely will be deemed material.

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Price Reporting

• Although there is no duty to report trade prices to publications that create indices, if a company does voluntarily report its trade prices for jurisdictional transactions, and intentionally reports them falsely, this likely would violate FERC’s rule.

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FERC’s Prior Market Behavior Rules

• FERC’s new rule replaces, in part, and supplants, in part, several “market behavior” rules adopted previously by FERC.

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Examples of Prohibited TransactionsSome trading practices prohibited by FERC’s old market behavior rules are now prohibited by FERC’s new rule, including, for example:

a. pre-arranged offsetting trades of the same product among the same parties, which involve no economic risk and no net change

in beneficial ownership (i.e., "wash trades"); 

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b. transactions predicated on submitting false information to transmission providers or other entities responsible for operation of transmission grid (such as inaccurate load or generation data or scheduling non-firm service or products sold as firm);

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c. transactions in which the entity first creates artificial congestion and then purports to relieve such artificial

congestion; and

  d. collusion with another party for the purpose of manipulating market

prices, market conditions, or market rules for electricity.

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• FERC views all of these activities as “manipulative or deceptive devices or contrivances” that are prohibited by FERC’s new rule.

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Defenses• If a market participant undertakes an action or

transaction that is explicitly contemplated in Commission-approved rules or regulations, FERC will presume the participant is not in violation of FERC’s rule.

• If a market participant undertakes an action or transaction at the direction of an ISO or RTO, the participant generally can assert this as a defense.

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• However, if a market participant acting with the requisite scienter has provided inaccurate or incomplete information to the ISO or RTO, and the ISO or RTO issues a directive in reliance on the false or incomplete information, following such ISO or RTO directive is not a legitimate defense.

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LESSONS LEARNED FROM PRIOR FERC INVESTIGATIONS

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Enron Trading Practices• Following the Western energy crisis of 2000-

2001, FERC investigated trading practices used by Enron and others with colorful names like Ricochet, Deathstar and Fat Boy.

• Deception or the submission of false and misleading information is an element common to each trading practice deemed unlawful by FERC.

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• FERC found that Enron’s trading practices violated provisions in the California ISO and PX tariffs restricting gaming and anomalous market behavior.

• FERC also found that Enron’s trading practices violated an implicit condition of all market-based rate authority granted by FERC, namely that “a company’s behavior will not involve fraud, deception or misrepresentation.”

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False Import Practice• False Import (a.k.a. “Ricochet" or "Megawatt

Laundering“) was a trading practice designed to mislead the ISO into believing that power had been imported from out-of-state in order to receive a price above the cap imposed on sales of generation inside the California market.

• As described by FERC, a market participant would purportedly export power purchased in the California day-ahead or day-of market, sell it to an out of state entity who would temporarily “park” the power for a small fee, and then repurchase it and sell it back in the California real-time market at a price above the market cap.

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• No power actually left the State of California, however, in this type of parking transaction. The market participant simply created a fictional export/import transaction to receive a price above the cap.

• Similar strategies to avoid market price caps through the submission of false or deceptive schedules also would likely violate FERC’s new rule.

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Congestion-Related Gaming Practices

• In the California ISO, market participants received “congestion relief payments” for relieving flows in the direction of congestion or increasing counter-flows in the opposite direction.

• Using a variety of deceptive practices, market participants submitted false schedules to create the impression of relieving congestion in order to receive these payments.

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Cutting Non-Firm • For example, Cutting Non‑firm (a.k.a. Non-firm

Export) involved the scheduling of non-firm power over a congested path by a market participant who did not intend to deliver any power.

• Upon receipt of a congestion payment for cutting the schedule, the market participant would cancel the non-firm power after the hour‑ahead market closed but keep the congestion payment.

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Ancillary Services-Related Practices• Paper Trading (a.k.a. Get Shorty) was a trading

practice whereby a market participant would sell ancillary services in the day-ahead market even though the market participant did not actually have the required resources available to provide the ancillary services. The market participant then bought back the ancillary services in the hour-ahead market at a lower price.

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– Double Selling (also a.k.a Get Shorty ) was a trading practice whereby a market participant would sell ancillary services in the day-ahead market from resources available at that time and then sell those same resources again as energy in the hour-ahead or real-time markets.

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Selling Non-Firm Energy as Firm

• Selling Non-Firm Energy as Firm was a trading practice whereby a market participant bought non-firm energy from outside California and then sold it to the ISO as firm energy.

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Authorized Trading Practices • FERC recognized practices which do “not involve any

false representations or take unfair advantage of ISO rules” are “appropriate and legitimate practices,” including for example:– Export of California Power - This practice involved a

purchase of power in the California day-ahead market at or below the price cap and then a resale of that power outside the state at a higher, uncapped price. Unlike the False Import practice, energy was actually exported out of California. FERC found this was a legitimate price arbitrage strategy. It would not violate the new rule because it does not involve the use of a device or scheme to defraud.

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– Ancillary Services Arbitrage – This practice involved selling ancillary services in the day-ahead market and buying them in the real-time market. So long as the market participant actually had the resources to provide the ancillary services, FERC found this was a legitimate arbitrage strategy.

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Investigations of Physical and Economic Withholding

• FERC investigated many electricity sellers to see if they engaged in either “physical” or “economic” withholding during the Western energy crisis.

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• Physical Withholding: A company unnecessarily takes a generation plant out of service to intentionally increase prices or create shortages.

• Economic Withholding: A company bids its generation into an organized market at a price that is inconsistent with, and significantly higher than, prevailing supply and demand conditions warrant, such as bidding $500/MW in a market that is clearing at $50/MW.

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FERC’s Enforcement Policy• FERC formalized its enforcement policy in a

Policy Statement (113 FERC ¶ 61,068 (2005)). • Chairman Kelliher summarized FERC’s policy as

“firm but fair enforcement.”• FERC expects a company to engage in

compliance training, auditing, and self-reporting and, generally, promote a “culture of compliance.”

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SEC, CFTC and DOJ Enforcement Policies

• FERC modeled its Enforcement Policy Statement on similar policy statements issued by the SEC, CFTC and DOJ.

• All of these policy statements take into account self-reporting and strong compliance programs when determining appropriate remedies for violations.

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Unjust Profits

• Although the Enforcement Policy Statement lays out mitigating factors FERC will consider when determining penalties, FERC announced that it will always require unjust profits be disgorged.

• Disgorgement is designed to prevent unjust enrichment whereas penalties are designed to punish and deter bad conduct.

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Penalty Determination Factors

• FPA Section 316A mandates that the “seriousness of the violation” be considered.

• Under the Enforcement Policy Statement, FERC will consider, among other things, the following factors: – extent and type of harm; – intent underlying the wrongdoing;

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– whether the company had a history of violations;

– senior management’s involvement in the violation;

– how the wrongdoing came to light; and

– the financial viability of the company.

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Credit for Cooperation

• FPA Section 316A requires FERC to consider efforts the company made to “remedy the violation in a timely manner.”

• “Credit” will be given to companies that:– self-monitor to prevent and stop misconduct;– self-report violations to FERC; and – cooperate with FERC’s enforcement action.

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• FERC will evaluate whether the company had:- a formal, independent compliance

program with sufficient resources and support by senior management;

- an ongoing process for auditing and training to comply with FERC’s regulations; and

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– an employee compensation, promotion, and discipline policy based on compliance with FERC’s rules and regulations.

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FERC also will consider whether:

• a company responded to prior wrongdoing by setting up internal controls to prevent future wrongdoing; or

• repeated prior violations.

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Self-Reporting

• FERC recognizes that companies are in the best position to detect and correct violations.

• FERC will give credit for self-reporting and take into account how the misconduct was uncovered. It will look at several factors, including whether:

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• the misconduct was uncovered by an internal audit;

• the company notified FERC promptly;

• senior management participated in and encouraged information gathering;

• the company took immediate steps to respond to and stop the misconduct;

• the company met with FERC Enforcement Staff and brought the relevant employees; and

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• the company presented the results of its investigation to Enforcement Staff, including

- full disclosure of the scope of the wrongdoing;

- who was involved;- what was done upon discovering the

violation; and- all relevant communications and documents.

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Exemplary Cooperation

• Although entities subject to FERC’s jurisdiction are required to provide information to FERC, credit will be given for exemplary cooperation.

• Factors FERC will consider in determining whether to give credit include whether the company:– volunteered to provide investigation or audit

reports;– hired an independent third-party to assist in the

investigation;

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– supported employee cooperation with the investigation;

– made records available to Staff and provided assistance in understanding the documents; and

– fairly and accurately determined the effects of the misconduct, including profits and who was affected adversely by the misconduct.

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Failure to Cooperate

• FERC also defined what it considers to be uncooperative conduct. This includes:

– failure to respond to data requests, produce documents or witnesses in a timely manner;

– misrepresenting the nature or extent of the misconduct;

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– falsely claiming that records are unavailable;

– limiting Staff access to employees;

– directing/influencing employees not to cooperate with the investigation;

– engaging in obstructive conduct during depositions or interviews;

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– providing inaccurate explanations for instances of misconduct that are uncovered;

– failing properly to search computer hard drives for documents and images; and

– failing to provide documents in the way they are maintained in the course of business.

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Compliance Plans

• In addition to monetary remedies, FERC has a tradition of requiring companies to adopt compliance plans to prevent a violation from recurring.

• These generally are written plans attached to a stipulation and consent agreement.

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Potential Compliance Plan Components

• Reporting quarterly to FERC

• Monitoring of communications

• Internal self-auditing

• FERC-approved staff training

• Document retention

• Hotline to report violations

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Indefinite Compliance Plan

• Although FERC compliance plans usually have a set time limit, in one investigation involving the alleged improper sharing of transmission information and abuse of native load priority, Idaho Power agreed to an indefinite compliance plan until FERC deemed the compliance plan could be ended for good cause shown.

• Additionally, FERC required Idaho Power to retain an independent auditor to ensure compliance with the Standards of Conduct.

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Coral Failure to Disclose • During FERC’s Westwide investigation,

Coral responded that it did not engage in false price reporting to indices.

• The CFTC informed FERC of Coral’s potential false reporting and, therefore, potential inaccurate responses to FERC’s data requests.

• Coral made a voluntary payment to FERC of $3.5 million to settle FERC’s investigation and agreed to develop a compliance plan.

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Enogex/Ozark Self-Reporting

• Ozark self-reported a pipeline construction violation, but was a repeat offender. It and its affiliate paid a total of $95,000.

• $20,000 was a voluntary payment by Ozark.

• $15,000 of the Enogex payment was waived for performing an outreach program to other industry members regarding clearances needed for pipeline construction.

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No-Action Letters

• Market participants can request “no-action” letters from FERC Staff before undertaking a questionable transaction.

• FERC’s no-action letter process is based on those of the SEC and CFTC. All three agencies state that no-action letters are not binding on the Commissions. Instead, they are binding only on the Staff of the division issuing the no-action letter.

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Potential No-Action Letter Responses

– Staff will not recommend enforcement action if the matter is implemented as described (Bottom line – it is ok as described).

– Staff will not recommend enforcement action if the matter is implemented under specific conditions stated in the response (Bottom Line – it is not ok as described, but would be ok if adopted with Staff’s suggestions).

– Staff may recommend enforcement action if the matter is implemented as so described (Bottom Line – don’t do this).

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Other Options for Advice • FERC considers avenues for informal advice

valuable, and intends its Staff to continue rendering informal, non-binding advice. Informal advice may be obtained, for example, through:

- Pre-Filing Meetings: Meetings between a company and FERC Staff to receive advice on filings the company plans to make.

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- Hotline Calls or Informal Inquiries: Calls can me made to FERC’s

Enforcement Hotline Staff to address questions or complaints. Also, FERC Staff might address questions raised through other informal inquiries.

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Binding Advice

• A binding Commission determination concerning a proposed transaction, practice, situation or other matter can be requested by filing a petition for a declaratory order. (18 C.F.R. § 385.207).

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Examples of Steps to Take to Ensure Continued Compliance

• Have a written compliance plan and conduct mandatory compliance training and audits on an ongoing basis.

• Have all relevant employees attend and sign training acknowledgements.

• Monitor FERC investigative orders, no- action letter responses, settlements and compliance plans, and keep track of changes in FERC’s rules.

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• Establish data retention and monitoring practices for e-mail, instant messages, electronic documents, tape recordings and trade capture systems.

• Listen to voice recordings and read instant messages and emails particularly on peak trading days (e.g., high LMP days in organized markets and days with price spikes or extreme hot or cold temperatures).

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• Perform an analysis of a trader's and a desk's trades for indications of any aberrant trading patterns. There are software systems that can perform these analyses.

• Meet regularly with traders to discuss their trading practices and compliance issues, solicit and answer their regulatory questions, and give reminders on best practices.

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• If you suspect or learn of wrongdoing, have an independent third party (i.e., an outside law firm) conduct an investigation for your utility promptly.

• If the investigation determines a violation occurred or there is a great likelihood a violation occurred in connection with a jurisdictional transaction, it could benefit your company to report the violation to FERC.

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• Giving the results of your investigation to FERC may:

– help focus FERC’s investigation more narrowly to specific violation you uncovered;

– save your utility money through lower legal fees and penalties;

– mitigate adverse publicity; and– maintain good government relations.

Benefits of Self-Reporting

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Bottom Line• FERC places a high value on compliance

training, auditing, self-reporting and cooperation and will take these factors into account when determining appropriate penalties for violations.

• On the other hand, if Enforcement Staff feels a company is uncooperative or failed to take appropriate steps to prevent, detect and report violations, FERC may impose the full extent of its penalties.