US legal and regulatory developments Prohibition on energy market manipulation

US legal and regulatory developments Prohibition on energy market manipulation Ian Cuillerier Hunton & Williams, 200 Park Avenue, 52nd Floor, New York, NY 10166-0136, USA. Tel. +1 212 309 1230; Fax. +1 212 309 1100; E-mail: icuillerier@hunton.com Ian Cuillerier is Partner in the New York office of the law firm of Hunton & Williams LLP and is co-head of the firm s Derivative Group. He specialises in advising financial institutions, hedge funds and corporate users in a wide variety of derivative transactions with a particular focus on the application of derivatives to structured transactions. He has also advised users in a number of commodity swaps, rate swaps, total return swaps and credit default swaps. Derivatives Use, Trading & Regulation, Vol. 12 Nos. 1/2, 2006, pp. 167 175 Palgrave Macmillan Ltd 1747 4426/06 $30.00 OVERVIEW Late in summer 2005, the Energy Policy Act of 2005 1 (the Energy Act ) became law. Section 315 of the Energy Act, which amends the Natural Gas Act 2 (the NGA ) by adding a new Section 4A, and Section 1283 of the Energy Act, which amends the Federal Power Act 3 (the FPA ) by adding a new Section 222, prohibit the use or employment of manipulative or deceptive devices or contrivances in connection with the purchase or sale of natural gas, electric energy or transportation or transmission services subject to the jurisdiction of the Federal Energy Regulatory Commission (the FERC or the Commission ). These prohibitions are modelled after and closely track Section 10(b) of the Securities Exchange Act of 1934 4 (the Exchange Act ). Indeed, the Energy Act provides that manipulative or deceptive devices or contrivance is to be understood as used in Section 10(b) of the Exchange Act. To implement Section 10(b) of the Exchange Act, the Securities Exchange Commission (the SEC ) adopted Rule 10b-5. On 19th January, 2006, the FERC issued Order No. 670, setting out its Final Rule to implement Section 4A of the NGA and Section 222 of the FPA. The text of the Final Rule is reproduced at the end of this article. The Commission modelled its Final Rule on Rule 10b-5, stating that this approach will benefit entities subject to the new rule because there is a substantial body of precedent applying the comparable language of Rule 10b-5. 5 A Notice of Proposed Rulemaking ( NOPR ) had been issued on 20th October, 2005, to prohibit market manipulation. In response to this NOPR, many interested stakeholders submitted comments to the FERC. Many of the issues raised in those comments were discussed in the preamble to the Final Rule. In respect of each issue discussed, the Derivatives Use, Trading & Regulation Volume Twelve Numbers One/Two 2006 167

FERC provided its determination. Those determinations, among other things, clarified the scope of the Final Rule, addressed disclosure issues, spoke to the elements of a violation of the Final Rule and dealt with implementations concerns. From the proposed text in the NOPR to the Final Rule, only the word person was changed to entity in Sections 1c.1(a)(3) and 1c.2(a)(3) of the Final Rule. Also, the Final Rule was placed in Part 1c of the Commission s general regulations, as opposed to being incorporated in two separate sections as originally proposed by the NOPR. 6 The FERC outlined that, without a rule prohibiting manipulative or deceptive conduct, the language of the Energy Act does not render certain behaviour unlawful. The Final Rule functions as the implementing provision to prohibit these behaviours in the markets that the FERC is charged with regulating. The intent of the Final Rule is not to regulate negligent practices or corporate mismanagement. It is intended to deter or punish fraud in the markets subject to the FERC s jurisdiction. 7 In the preamble to the Final Rule, the FERC discussed the scope of the Final Rule, the applicability of securities law precedents to determinations to be made under the Final Rule and to the energy industry, disclosure implications of the Final Rule, the elements that make up a violation of the Final Rule, the relationship between the Final Rule and Market Behavior Rules, and a variety of procedural matters. Let us now turn to consider the discussion and guidance provided by the FERC in its Order No. 670. SCOPE OF THE FINAL RULE In their comments, interested stakeholders asked the FERC to clarify the meaning to be given to the following terms as they apply to the regulation: any entity and subject to the jurisdiction of the Commission. 8 Some commentators suggested the meaning given to the term entity needs to include all types of entities and that the term be given the broadest possible meaning so as to include all entities participating in the market. Others cautioned that certain entities are not subject to the jurisdiction of the FERC and hence should not be subjected to the Final Rule. For example, entities involved in first sales 9 of natural gas should not fall within the ambit of any entity. Commentators likewise sought clarity as to whether the phrase subject to the jurisdiction of the Commission applied to boththepurchaseorsaleofelectricenergy and the purchase or sale of transmission services. In addition, the FERC was also asked to modify explicitly the proposed rule to make clear that the Final Rule addressed only market manipulation. 10 The FERC confirmed that the Final Rule does not, and is not intended to, expand the type of transactions subject to the Commission s jurisdiction under the FPA, NGA, Natural Gas Policy Act of 1978 11 (the NGPA ) or the Interstate Commerce Act 12 (the ICA ). 13 The FERC confirmed that, as directed by NGA Section 4A and FPA Section 222, the Final Rule does apply to any entity. Any entity is an inclusive term. No form of organisation is excluded. Regardless of 168 US legal and regulatory developments

legal status, all persons and organisations are within the term s scope. The text of Section 4A of the NGA, reads as follows: It shall be unlawful for an entity, directly or indirectly, to use or employ, in connection with the purchase or sale of natural gas or the purchase or sale of transportation services subject to the jurisdiction of the Commission, any manipulative or deceptive device or contrivance (as those terms are used in Section 10(b) of the Securities Exchange Act of 1934 (15 U.S.C. 78j(b))) in contravention of such rules and regulations as the Commission may prescribe as necessary in the public interest or for the protection of natural gas ratepayers. Nothing in this section shall be construed to create a private right of action. The text of Section 222 of the FPA, reads as follows: (a) IN GENERAL. It shall be unlawful for any entity (including an entity described in section 201(f)), directly or indirectly, to use or employ, in connection with the purchase and sale of electric energy or the purchase or sale of transmission services subject to the jurisdiction of the Commission, any manipulative or deceptive device or contrivance (as those terms are used in section 10(b) of the Securities Exchange Act of 1934 (15 U.S.C. 78j(b))), in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of electric ratepayers. (b) PRIVATE RIGHT OF ACTION. Nothing in this section shall be construed to create a private right of action. These Sections of the NGA and the FPA render it illegal for any entity to use a manipulative or deceptive device or contrivance in connection with the purchase or sale of natural gas or of transportation services subject to the jurisdiction of the Commission or the purchase or sale of electric energy or of transmission services subject to the jurisdiction of the Commission. The FERC stated that the key to the scope of the application of the Final Rule is found in a reasonable reading of these terms in relation to each other. 14 Also, the FERC concluded that the phrase subject to the jurisdiction of the Commission modifies both (1) the purchase and sale of natural gas or electric energy, as applicable, and (2) the purchase and sale of transportation services or transmission services. Otherwise, explained the FERC: [had] Congress intended to expand the Commission s jurisdiction so significantly as to give it anti-manipulation authority over such transactions as first sales of imported natural gas, intrastate sales of electric energy, retail sales of electric energy or energy sales by government entities, [the FERC] believes it would have done so explicitly. 15 Finally, where a conduct by an entity is US legal and regulatory developments 169

found to be manipulative and it is in connection with a jurisdictional transaction, the FERC s authority under the Final Rule will apply. The FERC s decision to use the phrase in connection with was explained by referencing the identical term used in Section 10(b). This has been interpreted broadly by the Supreme Court to include circumstances where a securities transaction and the scheme to defraud coincide. The FERC pointed out however that the Supreme Court was careful to state that Section 10(b) must not be construed so broadly as to convert every common law fraud that happens to involve securities into a violation of Section 10(b) and Rule 10b-5. 16 It is not the intent of the Final Rule to convert, explains the FERC, every common-law fraud that happens to affect a jurisdictional transaction into a violation thereof. An entity must have intended to affect, or have acted recklessly to affect, a jurisdictional transaction in the commission of the fraud. The FERC will be guided by this principle. It will therefore look for the nexus between the fraudulent action and the transactions over which the FERC has jurisdiction. It is interesting to note that, in contrast to what Cinergy Services has proposed, the FERC refused to state explicitly that the Final Rule only applies to market manipulation. It did so for fear of inappropriately narrowing the authority granted to it by Congress in the Energy Act. Instead, the FERC referenced the broad anti-fraud catch-all nature of Section 10(b) of the Exchange Act, and mentioned that its approach will permit it to police all forms of fraud and manipulation that affect natural gas and electric energy transactions and activities the Commission is charged with protecting. 17 APPLICABILITY OF SECURITIES LAW CONCEPTS TO THE FINAL RULE Many commentators complained that the application of the SEC s disclosure-based approach was troubling in the context of wholesale energy markets. They argued that the design of Rule 10b-5 is in keeping with its objective of levelling the playing field by eliminating access to information disparities and that open access or, more appropriately, equal access is intended to protect novice investors. In energy markets, however, where participants are large sophisticated players, there is no need for similar protection. In addition, industry stakeholders were troubled by the possibility of not having a clear idea of what conduct was inappropriate. They requested further consideration of this important issue so that the Final Rule would be more properly tailored to the energy markets. By rejecting arguments that modelling the Final Rule on Rule 10b-5 would create uncertainty, the FERC acknowledged the validity of the concerns raised and stated that its intent is to adapt analogous securities precedents to the facts, circumstances and situations of the energy market. This is in keeping, mentioned the FERC at 30 of Order No. 670, with how closely Congress modelled the Energy Act on Section 10(b) of the Exchange Act and with the explicit references to this section in the text of the relevant provisions of the 170 US legal and regulatory developments

Energy Act. The Commission found that the NOPR, just like Rule 10b-5 upon which it is modelled, is neither vague nor overly broad. In addition, the FERC generally agreed with comments given to the NOPR that a wholesale overlay of the securities laws onto energy markets is overly simplistic. 18 It added the SEC does not have a duty to assure that the price of a security is just and reasonable, and that our duty is not to protect purchasers through a regime of disclosure. 19 However, the FERC went on to say that ignoring the useful guidance thatthesecuritieslawsprovideswouldbe illogical. The FERC intends to recognise, based on the facts and circumstances of each case, that its role is different from that of the SEC in determining whether a given precedent is appropriate for the energy markets. DISCLOSURE REGIME Understandably, the commentators expressed a great deal of concern and fear that a disclosure-based regime, which has no place in bilateral negotiations, was being put into place. The FERC addressed both whether the proposed anti-manipulation regulations create a duty of disclosure and whether Sections 1c.1(a)(2) and 1c.2(a)(2), with the references to omissions of material fact, unduly burden market participants. Duty of disclosure Commentators presented many circumstances that could give rise to a duty to disclose that would hamper their negotiating positions. Disclosing trade secrets and sensitive information about the market were among them. Clarity was requested of the Commission in the Final Rule; clarity in the circumstances under which disclosure would be required to prevent incompatibility with bilateral transactions. The FERC did not modify the Final Rule, but instead clarified that, in the absence of any tariff requirement or FERC directive mandating disclosure, there is no disclosure requirement. The Final Rule does not adopt the disclosure provisions of the securities laws. The Commission states that [n]othing in the Final Rule requires disclosure of sensitive information that would only function to weaken an entity s bargaining position in arm-length, bilateral negotiations. 20 Omission of material facts Sections 1c.1(a)(2) and 1c.2(a)(2) of the Final Rule, and specifically the references therein to omission of material facts, generated many comments. Again, stakeholders insisted that the provisions be clarified, that the references to omissions of material facts be deleted or that the provisions be deleted altogether. Otherwise, a general duty to disclose could arguably be created with far-reaching unanticipated consequences. The Commission determined that there was no need to alter the NOPR and reaffirmed that the Final Rule does not create any affirmative duty to disclose. However, there is a duty not to misrepresent or to omit a material fact such that the information provided is materially misleading where an entity voluntarily US legal and regulatory developments 171

provides information or where the entity is required by tariff or a Commission statute, order, rule or regulation to provide information. 21 Whether or not such misrepresentation or omission occurs in or has the effect on jurisdictional transactions will be key in the Commission s consideration of whether to pursue any enforcement action against an entity. This will be determined on a case-by-case basis and, absent any such effect, the Commission will most likely not take any action. Sections 1c.1(a)(3) and 1c.2(a)(3) and intent Section 1c.1(a)(3) and Section 1c.2(a)(3) of the Final Rule do not incorporate any element of knowledge or intent. Many argued that the NOPR should be revised to reflect these elements. However, the FERC rejected these requests. It stated that there is no violation of the Final Rule without a showing of the requisite scienter. Elements of a claim Market participants and stakeholders sought clarity from the Commission in the Final Rule as to the elements of a claim under themanipulationrule.thedegreeof materiality and the requirement of scienter, among other things, were highlighted. Some commentators suggested that the elements of a claim should include scienter, causation, reliance and damages. Although the Commission agreed that greater clarity is required, it did not deem it necessary to modify the Final Rule to provide same. Instead, it set out the general requirements of a claim in the preamble to the Final Rule. In so doing, the Commission was guided by the securities laws and by the elements the SEC must demonstrate when it brings an enforcement action. In seeking precedent in securities law, the Commission looked to the decision in SEC v. Monarch Funding Corp. 22 It stated that the SEC is required to demonstrate that the defendant: (1) made a material misrepresentation or a material omission as to which he had a duty to speak, or use a fraudulent device; (2) with scienter; and (3) in connection with the purchase or sale of securities. 23 Guided by the securities law precedents, the FERC stated that it will pursue enforcement action in cases where an entity: uses a fraudulent device, scheme or artifice, or makes a material misrepresentation or a material omission as to which there is a duty to speak under a Commission-filed tariff, Commission order, rule or regulation, or engages in any act, practice, or course of business that operates or would operate as a fraud or deceit upon any entity; (2) with the requisite scienter; (3) in connection with the purchase or sale of natural gas or electric energy or transportation of natural gas or transmission of electric energy subject to the jurisdiction of the Commission. 24 Fraud is to be given a broad meaning in this context and is a question of fact that is to be considered based on the particularities of the case. Materiality with respect to misrepresentations or omissions will be established if there is a substantial likelihood that a reasonable market participant would consider the applicable fact in making its decision to transact 172 US legal and regulatory developments

because the material fact significantly altered the total mix of information available. 25 Quoting the Supreme Court, the Commission confirmed that a violation of the Final Rule requires the showing of scienter. The Commission will look for knowing or intentional misconduct, conduct designed to deceive or defraud. These elements, in the view of the Supreme Court, are strongly suggested by the references to the terms manipulative or deceptive used in conjunction with device or contrivance. 26 The Commission added that recklessness also satisfies the scienter element of the Final Rule. In addition, there is no requirement for the FERC to demonstrate reliance, causation or damages in order to pursue any enforcement action. The FERC stated, however, that the presence of these elements will inform the Commission s assessment of any disgorgement or civil penalties that may be appropriate under the circumstances. 27 Market Behavior Rules In 2003, the FERC had amended all market-based rate tariffs and authorisations to incorporate Market Behavior Rules. The Market Based Rules generally prohibit market manipulation by public utility sellers acting under market-based rate authority. Commentators raised concerns about the interrelationship between the NOPR and the Market Behavior Rules. At the time the Final Rule was issued, the Commission indicated its intent is to have a smooth transition from the Market Behavior Rules to the Final Rule in the event it decides to rescind any Market Behavior Rule. The FERC stated that the transition will not have any gap in prohibition on manipulation. The Commission issued an order on 16th February, 2006, wherein it rescinded Market Behavior Rules 2 and 6. 28 Market Behavior Rule 2 prohibited actions or transactions that are lacking a legitimate business purpose and that are intended to or foreseeably could manipulate market prices. In addition, Rule 2 prohibited certain specific conduct. It prohibited wash trades, transactions predicated on submitting false information, the creation and relief of artificial congestion and collusion for the purpose of market manipulation. These specific conducts are all prohibited under the Final Rule. The Commission was also concerned about allowing a lesser standard of proof apply to certain market participants, specifically public utility market-based rate sellers, and stated that the same standard of proof should apply to all entities and all jurisdictional sales. It is also important to note that the legitimate business purpose defence of Rule 2 is no longer available under the Final Rule. Statute of limitations The Commission declined to designate a statute of limitations or to in any way establish an arbitrary time period during which enforcement actions may be pursued. The Commission noted, however, that they intend for any administrative action for violation of the Final Rule to be initiated withinfiveyearsofthedatetheclaimfirst accrued (ie the date of the fraudulent or deceptive conduct). US legal and regulatory developments 173

Effectiveness The Final Rule became effective on the date of its publication in the Federal Register, 26th January, 2006. Civil penalty authority It is also important to note that the authority of the FERC to impose civil penalties was increased under the Energy Act from $10,000 to $1,000,000 per day for each violation and that it increased the ceiling on criminal penalties from $5,000 to $1,000,000. This penalty authority is similar to that of other federal economic regulatory authorities. No action letter In a statement, the Chairman of the Commission, Joseph T. Kelliher, commented on the Final Rule. He said that Congress has given the Commission this new authority in response to changes in the wholesale power and gas markets. New tools were required to achieve the same objective, that of protecting the wholesale power and gas customer. The FERC, in recognising the need for regulatory certainty and the consequences to the market of failing to provide this certainty, initiated a no action letter process. Under this process, parties can request guidance on whether a proposed transaction or practice is acceptable under the Final Rule. Ian Cuillerier APPENDIX In consideration of the foregoing, under the authority of the Energy Act, the Commission amends Chapter I, Title 18, Code of Federal Regulations, as follows: Part 1c is added to read as follows: Part 1c Prohibition of energy market manipulation Sec. 1c.1 Prohibition of natural gas market manipulation. 1c.2 Prohibition of electric energy market manipulation. Authority: 15 U.S.C. 717-717z; 16 U.S.C. 791-825r; 2601-2645; 42 U.S.C. 7101-7352. 1c.1 Prohibition of natural gas market manipulation (a) It shall be unlawful for any entity, directly or indirectly, in connection withthepurchaseorsaleofnatural gas or the purchase or sale of 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 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. (b) Nothing in section shall be construed to create a private right of action. 174 US legal and regulatory developments

1c.2 Prohibition of electric energy market manipulation (a) It shall be unlawful for any entity, directly or indirectly, in connection withthepurchaseorsaleofelectric energyorthepurchaseorsaleof transmission 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. (b) Nothing in this section shall be construed to create a private right of action. References 1 Energy Policy Act of 2005, Pub. L. 109-58, 119 Stat. 594 (2005). 2 5 U.S.C. 717 et al. (2000). 3 16 U.S.C. 791a et al. (2000). 4 Securities Exchange Act of 1934, 15 U.S.C. 78j(b) (2000). 5 Prohibition of Energy Market Manipulation, 114 FERC 61,047 (Order No. 670), at 7. 6 The proposed text of Section 159.1 and Section 47.1 will now be new Section 1c.1 and Section 1c.2, respectively. 7 Ref. 5 above, at 5. 8 See Section 1c.1(a) and Section 1c.2(a) of the Final Rule. 9 First Sales of natural gas are sales that occur in certain wholesale markets and were excluded from the FERC s jurisdiction by the Natural Gas Policy Act of 1978 and the Wellhead Decontrol Act of 1989. 10 Ref. 5 above, at 15. Cinergy Services, Inc. highlighted that the SEC Rule 10(b)-5 addresses a wide range of activities and not only market manipulation. 11 See 15 U.S.C. 3431(a)(2)(A) (2006) of the Natural Gas Policy Act of 1978 (15 U.S.C. 717 et al. (2000)) for a description of FERC s jurisdiction under such Act. 12 See 49 U.S.C. 60502 (2002) of the Interstate Commerce Act (Pub. L. 103-272, Sec. 1(e) (1994)) for a description of FERC s duties and powers under such Act. 13 Ref. 5 above, at 16. 14 Ref. 5 above, at 17. 15 Ref. 5 above, at 20. 16 Ref. 5 above, at 22. 17 Ref. 5 above, at 25. 18 Ref. 5 above, at 31. 19 Ref. 5 above, at 32. 20 Ref. 5 above, at 36. 21 Ref. 5 above, at 41. 22 SEC v. Monarch Funding Corp., 192 F. 3d 295, 308 (2d Cir. 1999). 23 Ref. 5 above, at 48. 24 Ref. 5 above, at 49. 25 Ref. 5 above, at 51. 26 Ref. 5 above, at 52. There the Commission references Ernst & Ernst v. Hochfelder, 425 U.S. 185, 197 (1976) and Aaron v. SEC, 446 U.S. 680, 690 (1980). 27 Ref. 5 above, at footnote 102 in 48. 28 Investigation of Terms and Conditions of Public Utility Market-Based Rate Authorizations, 114 FERC 61,165, 2006. US legal and regulatory developments 175