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OVERVIEW OF ENERGY OVERVIEW OF ENERGY TRADING ISSUESTRADING ISSUES

Peggy A. HeegPartner, Fulbright & Jaworski L.L.P.

Global Energy Management InstituteUH-GEMI 3rd Annual Energy Trading and

Marketing Conference: Rebuilding the BusinessJanuary 20, 2005

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FERC Market Behavior RulesFERC Market Behavior Rules

Peggy A. Heeg

Partner, Fulbright & Jaworski L.L.P.

January 20, 2005

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FERC Investigation of Trading PracticesFERC Investigation of Trading Practices

Investigation of market manipulation strategies and the California energy crisis.

“Particularly troubling is the common theme that because everyone knew that everyone else was manipulating the indices by reporting false prices and volumes, it was somehow acceptable and even necessary for this to take place.” Final Report on Price Manipulation in Western Markets.

FERC concluded that rapid-fire trading, Enron-like trading strategies, wash trades, economic withholding and inflated bidding distorted prices in the Western United States.

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The Market Behavior RulesThe Market Behavior Rules

FERC issued two orders establishing market behavior rules for traders.

The gas and electric rules are similar; the electric rules contain additional rules that address physical operations of generating facilities and interactions with grid operators.

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FERC Market Behavior RulesFERC Market Behavior RulesMarket ManipulationMarket Manipulation

The rules prohibit actions or transactions that are without a legitimate business purpose and that are intended to or foreseeably could manipulate market prices, market conditions, or market rules for electric energy or electricity products.

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FERC Market Behavior RulesFERC Market Behavior RulesMarket ManipulationMarket Manipulation

“We clarify that transactions with economic substance, in which a seller offers or provides service to a willing buyer and where value is exchanged for value, are not prohibited by our rule . . . Behaviors and transactions with economic substance will thus be recognized as reflecting a legitimate business purpose consistent with just and reasonable rates.”

The Commission declined to clarify the meaning of “legitimate business purpose” in the Order on Rehearing and suggests that the rule is deliberately vague.

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FERC Market Behavior RulesFERC Market Behavior RulesMarket ManipulationMarket Manipulation

Prohibited actions and transactions include, but are not limited to:

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 (sometimes called "wash trades");

b. transactions predicated on submitting false information to transmission providers or other entities responsible for operation of the transmission grid (such as inaccurate load or generation data; or scheduling non-firm service or products sold as firm), unless Seller exercised due diligence to prevent such occurrences;

c. transactions which create artificial congestion and then purport to relieve such artificial congestion (unless Seller exercised due diligence to prevent such an occurrence); and

d. collusion with another party for the purpose of manipulating market prices, market conditions or market rules.

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FERC Market Behavior RulesFERC Market Behavior RulesReporting To IndicesReporting To Indices

Seller shall provide accurate and factual information to indices and not knowingly submit false or misleading information or omit material information to any such publisher.

Data providers that can demonstrate that they have adopted and followed Commission standards for price reporting will be presumed to have submitted accurate and timely information.

The Commission will not prosecute and/or penalize parties for inadvertent errors in reporting, nor will it refer such issues to other agencies having jurisdiction.

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FERC Market Behavior RulesFERC Market Behavior RulesRecord RetentionRecord Retention

Seller shall retain, for a period of three years, all data and information upon which it billed the prices it charged or the prices it reported for use in price indices.

Sellers must retain the complete set of contractual and related documentation upon which they billed their customers for their sales.

The Commission is “indifferent” as to whether this material is retained in paper form or in an electronic medium as long as the data can be made accessible in a reasonable fashion if its review is required by the Commission or its Staff.

The Commission clarified on rehearing that it wants to be able to track the entire transaction, starting with the inception of the transaction.

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FERC Market Behavior RulesFERC Market Behavior Rules

On rehearing, the Commission declined to further clarify the record retention rule.

“We also decline to clarify our rule further with the addition of such distinctions as primary versus secondary records and documents which may or may not have been expressly relied upon by the seller … If a given record includes information that fits this description, it must be retained … regardless of the medium in which the record is maintained (whether a contractual document, email, or other record).”

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Procedural Limitations for Alleged ViolationsProcedural Limitations for Alleged Violations

Complaint must be brought within 90 days of: 1) the end of the Quarter in which violation is alleged to have occurred; or 2) when the Complainant should have known of the behavior.

Commission must act within 90 days from the date it knew of the alleged violation.

Commission action on filing not meeting filing deadlines shall be prospective only.

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Consequences of Violating the Market Consequences of Violating the Market Behavior RulesBehavior Rules

There are no Commission orders which provide guidance in interpreting the Market Behavior Rules.

Despite the lack of guidance provided by FERC, the consequence of non-compliance is severe.

Remedies for violations:

– Disgorgement of unjust profits

– Revocation of its authority to sell at market-based rates

– Other appropriate non-monetary remedies FERC is a member of Corporate Fraud Task Force.

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Conclusions Conclusions

FERC has exercised jurisdiction over trading companies. FERC has adopted an extremely broad set of rules that are vague

and subject to interpretation. In some instances this vagueness appears deliberate. Given the intentional vagueness in the rules, market participants

should proceed cautiously:

– Detailed compliance procedures

– Education

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Commodity Futures Trading Commodity Futures Trading CommissionCommission

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Commodity Futures Trading CommissionCommodity Futures Trading Commission

Since 2002, the CFTC has investigated over 40 energy companies and numerous individuals.

Thus far, the CFTC has filed 20 actions and collected over one-quarter billion dollars in penalties; settlements include ongoing obligations to cooperate.

Cases have dealt primarily with false price reporting to trade publications.

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Commodity Futures Trading CommissionCommodity Futures Trading Commission

What is the Commodity Exchange Act?

– Originated in 1922 as the Grain Futures Act

– Commodity Exchange Act gives CFTC exclusive jurisdiction over energy futures contracts

CFTC becoming more aggressive in exercising its jurisdiction under the Commodity Exchange Act.

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Commodity Exchange ActCommodity Exchange Act

Commodity Exchange Act makes it unlawful for a person to “manipulate or attempt to manipulate the price of any commodity in interstate commerce … or knowingly to deliver or cause to be delivered … false or misleading or knowingly inaccurate reports concerning … market information or conditions that affect or tend to affect the price of any commodity in interstate commerce.”

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Commodity Futures Trading CommissionCommodity Futures Trading Commission

CFTC has teamed up with FERC to monitor markets.

CFTC and FERC conducted a seven month investigation into gas price movements in late 2003 and recently concluded that price movement was a result of market forces.

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Commodity Futures Trading Commission Commodity Futures Trading Commission Cooperation AdvisoryCooperation Advisory

Outlines factors that CFTC will weigh in evaluating whether a company has cooperated with the CFTC. Factors include:

Self reporting Privilege waiver Provide financial analysis of

harm

No joint defense agreement Hire staff to respond to

subpoena Investigate facts

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False Price ReportingFalse Price Reporting

Practice was widespread.

One trading desk maintained a computer spreadsheet named “IFERC Bogus” for the purpose of providing inaccurate market information to Inside FERC.

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Criminal ProsecutionCriminal Prosecution

To date there have been criminal indictments against traders at Duke, Dynegy, El Paso, Enron, Reliant and Williams .

Majority of these are for false price reporting in violation of the Commodity Exchange Act.

Most recent charges have alleged conspiracy to manipulate the markets.

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Criminal ProsecutionCriminal Prosecution

Most recent plea arrangement with ex-Williams trader admitted that he knew how reporting false price information could benefit his trading position and that the false reporting affected the Inside FERC index price.

Most recent indictments allege conspiracy among traders in different companies to manipulate the price indices.

Cases will lead to litigation.

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CRIMINAL PROCEEDINGS AGAINST CRIMINAL PROCEEDINGS AGAINST INDIVIDUALSINDIVIDUALS

Traders from numerous companies have been criminally charged with a felony for violating the Commodities Exchange Act (7 U.S.C. § 13 (a) (2)) and wire fraud -- El Paso, Dynegy, Reliant and Williams.

In U.S. v. Valencia, Dynegy trader argued that CEA is unconstitutionally overbroad, is void for vagueness, only applies to futures transactions and infringes on speech protected by the first amendment.

On December 17, 2004, the Fifth Circuit concluded that the CEA is not unconstitutionally overbroad; statute requires that person submitting false or misleading information must know that information is false or misleading.

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For More Information

Please contact:

Peggy A. Heeg

(713) 651-8443

pheeg@fulbright.com