Online Exclusive: Understanding the compliance emphasis of FERC and its regulatory counterparts

by Gregory K. Lawrence, McDermott Will & Emery LLP

The financial and energy market turmoil of 2008 produced a groundswell of support for increased energy market regulation. While lower commodity prices may have reduced some of this pressure, both the U.S. Congress and the new senior energy and commodity regulators are likely to pursue greater regulatory oversight, as a market-based approach to regulation is questioned. That will shape the future policy actions of the new major energy regulatory authorities: Jon Wellinghoff, chair of the Federal Energy Regulatory Commission (FERC); Jon Leibowitz, chair of the Federal Trade Commission (FTC); and Gary Gensler, chair of the Commodity Futures Trading commission (CFTC).

Regulatory overlap

In this triple-headed regulatory structure, any stepped up enforcement and regulatory activity will likely be complicated by overlapping enforcement. Each of the three agencies technically has a different focus and sphere of influence:

* The FERC regulates wholesale purchase and sale transactions involving power and natural gas, as well as the electric power transmission grid and the pipeline transmission system. FERC primarily regulates physical energy market transactions, but also has some involvement in financial transactions.

* The CFTC is charged with enforcement against manipulation and fraud in cash commodities, such as crude, refined products, natural gas and power traded either as spots or forwards. It also regulates futures contracts, options on futures contracts, and OTC commodity options, including power and gas options. CFTC’s mandate against manipulation and fraud also encompasses financial OTC derivatives such as swaps.

* The FTC primarily focuses on antitrust and anticompetitive market concerns involving all energy products. FTC’s regulatory action takes enforcement against both market manipulation and false reporting of marketing activities.

Recent enforcement cases indicate that federal regulators are looking at energy traders’ combined transactions, including those executed on exchanges and OTC cash and derivatives markets. These cases reflect an assumption that price spikes are caused by improper trading, not market fundamentals. Regulators have made it clear that they will not give market traders the benefit of the doubt when it comes to suspicions of market manipulation, or any trading activity that seems questionable or appears to stretch the rules. At bottom, it is impermissible to create (or try to create) artificial market prices, or to disseminate false information that could affect market prices.

Moreover, the FERC and the CFTC have signed an information sharing memorandum, so that whatever is reported to one agency is available to the other. Market overlap with the FTC is bound to increase also. Having directed FERC in 2005 to promulgate an anti-manipulation rule predicated on Section 10(b) of the Securities Exchange Act of 1934, Congress in the Energy Independence and Security Act of 2007 gave the FTC authority to promulgate a similar rule designed to combat perceived manipulation in the physical, wholesale crude oil, gasoline and petroleum distillates markets. The FTC is expected to look to precedent developed under the FERC’s anti-manipulation rule for guidance. The FTC already has relied on the FERC’s experience in drafting a rule based on a very similar statutory mandate and has, in fact, taken the same approach to a number of important issues, including defining fraud broadly.

Misconduct and penalties

An informal or formal investigation of energy market manipulation can start in several ways and can also expand over time. Triggering factors include agency audits, competitor reports on market behavior including discussions with the FERC “hotline” or to independent system operators, exchange surveillance, or observation of physical market behavior, especially during times of volatility or system stress. Once an investigation is instigated from any of these sources, the FERC investigates for prohibited practices under its antifraud and manipulation rule. That rule prohibits any entity in connection with purchase or sale of natural gas or transportation, electric energy or transmission subject to FERC’s jurisdiction from:

* Using or employing any device, scheme, or artifice to defraud;
* Making any untrue statement of material fact or to omit to state a necessary material fact; and
* Engaging in any act, practice, or course of business that operates — or would operate — as a fraud or deceit upon any entity. (Fraud or deceit is defined as “any action, transaction, or conspiracy for the purpose of impairing, obstructing or defeating a well-functioning market.”)

The types of market conduct covered by these anti-manipulation and fraud prohibitions can vary significantly from case to case, and market to market. FERC also has delineated specific prohibited practices:

* False congestion transactions in which an entity first creates artificial congestion and then purports to relieve such artificial congestion;
* Collusion with another party for the purpose of manipulating market prices, market conditions, or market rules for electric energy or electricity products;
* Unlawfully withholding available supply from market in order to raise prices or create artificial supply shortages; and
* Economic withholding, which involves bidding available supply at sufficiently high price in excess of a supplier’s marginal costs and opportunity costs so that it is not called on.

Heightened enforcement for these offenses must be viewed against the already substantial and broad penalties that exist. Criminal penalties can include a fine of up to $1 million ($50,000 for each day of willful/knowing violation) and a maximum jail term of up to five years, with civil penalties up to $1 million per violation. Regulatory penalties can encompass disgorgement of profits, civil penalties, condition, suspension or revocation of marketing privileges (including a lifetime trading ban), or other non-monetary remedies. Such penalties can be costly and hurt the franchise reputation and stock values. Condition or suspension of market privileges also could cause defaults under existing contracts, for example.

Compliance programs

Both the FERC and CFTC encourage regulated entities to have comprehensive compliance programs and to develop a culture of compliance within their organizations. The FERC’s Revised Enforcement Policy Statement and the Policy Statement on Compliance, as well as the CFTC Cooperation Guidelines, identify the factors that the agencies will consider in determining the severity of penalties to be imposed for violations. Particular emphasis is on evidence that a company has made efforts to promote compliance — particularly steps taken to prevent, monitor, and immediately stop misconduct. Significant cooperation with investigations also could help reduce ultimate penalties.

The FERC’s Revised Policy Statement on Enforcement, issued in May 2008 and updated the following October, identifies the four factors that it considers important in establishing a successful compliance program: the role of senior management, effective preventive measures, detection and reporting of violations, and curative efforts.

In assessing the first factor, FERC believes senior management should be actively involved in any comprehensive compliance program through frequent communication of their commitment to compliance, setting aside time to address compliance issues as they arise, encouraging employees to seek advice regarding compliance issues and establishing a compliance position within the company structure.

The second factor demands that a compliance program must also include effective preventative measures through training, accountability, and supervision, not just a checklist of performance standards.

The third factor weighs whether companies have uncovered violations as the result of internal auditing, followed by voluntary disclosure of problems to FERC.

Finally, FERC considers curative efforts to include whether a company imposes reprimands, suspensions, compensation reductions and termination for those infringements by employees.

This enforcement apparatus is obviously substantial. Now, however, many in Congress want even more regulatory oversight and deeper enforcement. Catchwords like ‘enhanced safety,’ ‘accountability,’ and ‘transparency’ are paramount, and dovetail with the regulators’ own announced or presumed intentions at greater oversight. Energy market participants should prepare and strengthen their compliance programs and anticipate the potential for audits and investigations now for the new regulatory environment ahead.


Gregory K. Lawrence is a partner in the Energy and Derivatives Markets Group of global law firm McDermott Will & Emery. Mr. Lawrence focuses his practice on regulatory proceedings, compliance and investigations, negotiations, governmental affairs and agency litigation relating to the wholesale and retail electricity and natural gas industries.

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