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Amid intense political pressure to punish and prevent “market manipulation” after energy prices soared in the Western United States in 2000-01, the Federal Energy Regulatory Commission recently established market behavior rules for wholesale energy markets. Their stated goal is to help “prevent market abuse, provide a more stable marketplace, and create an environment that will attract needed investment capital in the electric and natural gas industries.” The new “rules of the road” cover market manipulation, price reporting, and record retention. The electricity rules also address unit operations — though FERC declined to impose a requirement that suppliers “must offer” for bid all available resources at all times, which some advocated. Whether these rules make sufficiently clear what is and is not prohibited behavior in wholesale energy markets is open to debate. Many might be tempted to throw up their hands in despair over the rules’ vagueness, but prudence suggests that companies do their best to institute strong compliance programs. That, at least, will minimize the risk that violations will occur, as well as the chance that FERC will impose stiff remedies. The truth is that, while undoubtedly laudable in their goal, FERC’s rules may not provide the hoped-for panacea. At best, they are purposefully broad to permit regulators to address new and unanticipated activities in the future. At worst, they are unconstitutionally vague and subject companies to punishment for conduct not clearly proscribed from the outset, but which FERC may later declare unacceptable (i.e., after the political pressure that inevitably follows any price spike). THE RULES OF THE ROAD The new rules apply to all power sales under FERC-authorized market-based rates and all natural gas sales under FERC-issued blanket certificates. The rules for wholesale power (which the rules for natural gas largely track) provide for the following: • Unit operation. Wholesale power sellers charging market-based rates must operate and schedule generating facilities, undertake maintenance, declare outages, and commit or bid supply in compliance with FERC-approved rules and regulations. • Market manipulation. Transactions without a legitimate business purpose that are intended to or could foreseeably manipulate market prices, conditions, or rules for electric energy, as well as any collusive acts to manipulate the market, are prohibited. Such transactions include so-called wash trades and transactions based on false information or used to create artificial congestion. • Communications. Sellers are required to provide accurate, factual information, and not to submit false or misleading information in any communications with FERC, FERC-approved market monitors, regional transmission organizations, independent system operators, or jurisdictional transmission providers. • Price reporting. Sellers that report prices must provide accurate, factual information, and not knowingly submit false or misleading information or omit information to any such publisher. But FERC did not mandate price reporting. • Record retention. Sellers must retain for three years all data — regardless of format or medium — upon which prices are billed to customers or reported to an index publisher. • Compliance with related tariffs. Wholesale power sellers must not violate or collude with another party in actions that violate the code of conduct for sellers with market-based rate authority or FERC’s standards for affiliate conduct. FERC views its responsibilities in enforcing market behavior rules as “mission-critical.” According to FERC, energy markets do not by themselves establish fair rules, provide a level playing field, constrain market power, or fix themselves when broken. These are FERC’s responsibilities in its evolving role as the “cop on the beat.” FERC began looking at imposing behavior rules in 2001. Two years later, it issued proposed rules after finding widespread trading conduct in the West “inconsistent with properly functioning wholesale energy markets.” According to some, significant political pressure — brought to bear especially by Western lawmakers, who accuse FERC of abdicating its responsibility to protect consumers — also played a role in the adoption of these rules. The rules are now final and in effect, although FERC must still defend them in a pending case before the U.S. Court of Appeals for the D.C. Circuit. THE TROUBLE WITH RULES FERC crafted these market behavior rules to allow it maximum flexibility to review future conduct alleged to harm competition or consumers. In FERC’s words, the “rules contain the breadth and flexibility to address new and unanticipated activities as they may arise.” This means the rules are broadly worded, read more like generic principles, and (by themselves) offer few specifics about what is “legitimate” and what is not. They expressly permit FERC to judge all energy trading conduct after the fact. That creates uncertainty, which may roil markets more than the rules calm them. FERC tried to mollify concerns about open-ended liability by prescribing a tight time frame for parties to complain about potential violations. Complaints alleging violations must be filed within 90 days of the calendar quarter in which the alleged violation occurred or from the time a reasonable person should have known of the violation. Thus, we should expect disputes about when a complainant knew or should have known of a violation. In addition, FERC said it will act on complaints within 90 days of being notified — and if it does not act within that time, the seller will not be exposed to potential liability regarding the relevant action or transaction. Numerous market participants also complained about the inherent vagueness in the prohibition of actions “without a legitimate business purpose” that are “intended to or foreseeably could” manipulate the market. FERC intends this rule to prohibit “anti-competitive behavior” and actions that lack “an appropriate commercial underpinning,” but not transactions with “economic substance.” However, the rule says little about what is a “legitimate” purpose or what actions are “appropriate.” Despite pleas from energy companies, FERC refused to specify, saying only that it would consider all facts and circumstances to determine whether harm was intended or foreseeable. According to some, FERC seemed to be assuring sellers, “You’ll know it when you see it.” To be fair, FERC’s orders regarding price manipulation in Western markets provide a guide as to what was considered manipulative in the past. But the new rules, particularly by banning conduct that is not “legitimate” or “appropriate,” are arguably broader. Considering that the rules allow for retroactive relief — not just the prospective relief otherwise contemplated by the Federal Power Act and the Natural Gas Act — notice and clarity are critical to their effectiveness. One example that FERC gave of conduct that will be deemed to have no legitimate business purpose is withholding power (and presumably gas as well) with the intent to manipulate the market. But the definitions of “withholding,” which have been the subject of much debate at FERC, are vague. Bottom line: If prices spike, be advised either to sell your resources fully or have a good excuse for any unused capacity. Another potential problem is the use of a “foreseeability” standard to determine if something violates the rules. The question is whether a reasonable person in the marketer’s shoes could have foreseen the harm. Yet FERC provided no clues about when an impact on prices is “foreseeable,” thus creating more fodder for litigation. Still another problem lurks in the prohibition against wash trades. FERC rejected calls to define wash trades as prearranged, offsetting trades executed at the same location and the same time. Instead, FERC defined wash trades as “purposefully created, prearranged off-setting trade[s] with no economic risk, and no net change in beneficial ownership.” Such transactions, in FERC’s view, constitute a per se violation even when the offsetting trade is executed at a separate time or for a different delivery point. That definition potentially sweeps into the rule’s ambit a range of legitimate transactions. For example, FERC said that arrangements to manage credit and counterparty risk (“sleeving”) or to manage transmission flow (“bookouts”) will not be prohibited, yet offered no guidance about when, in fact, a trade is considered “pre-arranged” or “offsetting.” FERC recognized that buyers and sellers trade the same products with the same parties repeatedly in a trading day, but contended that the rule against wash trading would not be implicated unless “parties purposefully create pre-arranged offsetting trades with no economic risk.” That doesn’t seem like much insight. Yet another potential issue concerns the record retention requirement. Sellers must now retain all data and information concerning the prices billed to customers or reported to index publishers. FERC clarified it was not requiring retention of cost-of-service or analytical data, but it does require keeping “a complete set of contractual and related documentation” upon which a seller billed its customers. Since this rule is indifferent as to the medium of the data, it could be interpreted as applying to all communications leading to an executed trade — all e-mail, voice mail, and instant messages, as well as hard-copy confirmations and invoices. BEING IN COMPLIANCE Concerns about the rules are serious because the sanctions could be quite severe. Those found in violation face not only disgorgement of profits but also suspension or revocation of trading authorization and other “appropriate non-monetary remedies.” While FERC declined a per se “make the market whole” remedy, it did not rule out the possibility that it might order that remedy in certain circumstances. Thus, the new behavior rules give companies a strong incentive to institute compliance programs and strong internal controls. Indeed, the rules offer a safe harbor in the context of rogue employees where the seller demonstrates that it “exercised due diligence to prevent the occurrence of the conduct at issue.” For example, demonstration of due diligence is a basis for showing lack of intent to violate. The flip side is that the rules also provide that if FERC finds a seller’s due diligence insufficient, it can infer a wrongful intent. A credible compliance program is thus important to minimizing the risk that trading activities will run afoul of the rules. So what do we conclude about FERC’s new market behavior rules? They are undoubtedly well-intentioned and, in many respects, mark an evolution in FERC’s efforts to standardize energy markets. The rules take an important step forward in promoting market integrity, as well as respect for market rules and institutions, while providing some clarity about what is appropriate behavior in wholesale energy markets. The various rules prohibiting the submission of false information, for example, seemingly provide a clear standard and reflect common sense. However, other aspects of the rules, such as the prohibitions of transactions that lack a legitimate business purpose, are not so well-defined. The challenge for FERC now is to apply the rules to individual cases. Given the apparent consensus in Washington for blaming the energy industry when prices are high, energy trading companies are well-advised to put effective compliance programs and other internal controls in place. By taking proactive steps to comply with the new rules, companies will improve the chances that they do not end up in FERC enforcement proceedings or facing expensive litigation. Kenneth W. Irvin and Kenneth M. Minesinger are partners in the D.C. office of Morrison & Foerster and members of the energy practice group. The authors wish to thank summer associate Ana-Maria Ignat.

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