By Rich Heidorn Jr.
FERC Moves on Case that Figured in Bay Nomination
In 2009, a Ph.D. electrical engineer turned energy trader shared with a suburban Philadelphia portfolio manager a seemingly unbeatable way to make money trading in the PJM market. The key was a poorly designed market rule that overcompensated up-to-congestion (UTC) trades with rebates for transmission line losses.
It was so easy, portfolio manager Kevin Gates said later, that “a monkey throwing darts at a dartboard” could have made money.
Gates feared PJM would realize its mistake before long. But in the meantime, he told his investment partners, they “should drive a truck through that loophole.”
That they did. By ramping up volumes on UTC trades that had little or no underlying risk, they made $4.7 million over five months in 2010 before PJM asked the Federal Energy Regulatory Commission to change the rule.
Four years later, the profits have shrunk, as Gates and his partners have spent more than $1.5 million on lawyers and consultants fighting a FERC investigation.
Last week, FERC staff issued a Notice of Alleged Violations against Gates and his partners, setting the stage for a showdown in a case that some critics say illustrates the excessive zealousness of FERC’s Office of Enforcement under former Director Norman Bay. The notice was filed the day after Bay was sworn in as the commission’s fifth member.
The facts, for the most part, are not in dispute. Thus the case will turn on legal interpretations: Were Gates’ trades riskless, and thus improper, “wash” trades, as FERC contends, or permissible “spread” trades? Did FERC provide proper notice that seeking profits through the line-loss rebates alone was improper? And if FERC thought it had a strong case, why did it wait nearly four years to bring it?
The following account of the case is based on records released by Gates and interviews with some of the principals.
Investment Fund Expands into Energy
Kevin Gates and his identical twin Rich manage private investment funds from an office in the Philadelphia suburb of West Chester, Pa. In 2008, the brothers met Houlian “Alan” Chen, who had emigrated to the U.S. in 1995 after receiving his doctorate degree in power engineering from Tsinghua University in Beijing.
Chen worked for about 10 years as a power analyst for several energy companies, creating models to forecast power prices, before forming his own investment fund in 2007.
Chen mostly traded up-to-congestion trades. UTCs, which load-serving entities use to hedge congestion risk, earn or lose money based on price changes between the day-ahead and real-time energy markets at individual pricing nodes. UTC traders profit if the difference between DA and RT prices is in the direction bid by the trader and the difference was large enough to cover the costs of scheduling the transactions.
Soon after meeting them, Chen began trading on behalf of the Gates brothers and their investors, who wanted to expand their investment options. Chen typically invested $4 of the Gates’ group cash for every $1 of his own.
Chen changed his trading strategy after he began receiving rebate payments, or transmission loss credits (TLCs), in October 2009.
Transmission Line Losses
PJM charges those moving power on its grid a fee to account for line losses — energy lost as heat during transmission. PJM’s method treated every transmission as if it were the last transmission in the system. Because this charged each buyer for the most problematic transmission at the time, it collected far more than actual losses.
As a result, PJM won FERC approval for a mechanism to refund the overcollections to traders, the Marginal Loss Surplus Allocation (MLSA). (See Split Decision for Financial Traders on PJM Line-Loss Collections.)
Although UTCs don’t involve the movement of physical energy, UTC traders then had to reserve transmission service for each transaction, making them eligible for the line-loss rebates.
Chen discovered the rebates were far more than what he had paid for line losses and thus a potential source of profits. After several months of this found money, Chen and his investors began increasing the volume of their trades in February 2010. They were among a handful of traders who PJM says netted $19 million in unjust profits through the rebates.
Paired Trades
To profit on the rebates and limit the risk of loss due to the DA-RT price differences, Chen made paired trades, buying a day-ahead position in MISO and selling it at a point in PJM, while doing the same thing in the opposite direction.
At first, Chen chose an A-to-B, B-to-C trading formula, choosing “A” and “C” nodes whose prices closely tracked each other, such as Mount Storm, W.Va., site of Dominion’s largest coal-fired generator, and Greenland Gap, W.Va., the location of a Dominion wind farm 11 miles to the east. One of his favorite trades was Mount Storm to the MISO interface paired with MISO to Greenland Gap.
Had he and the Gateses continued this pattern, FERC might not be pursuing him now.
But on May 30, 2010, Chen and his partners were shocked when the UTC between MISO and Greenland Gap unexpectedly spiked and the Mount Storm-MISO trade that was intended to offset it failed to move.
Chen’s trades lost almost $180,000 on the change in price spreads. The $18,000 in scheduling costs was offset by the $22,000 in line-loss rebates, resulting in a net loss of more than $176,000.
Chen told Kevin Gates that the large volume of his trades may have contributed to the divergence between the two legs, saying “I suspect the trades we put on affected the day-ahead model runs.”
As a result, Chen changed his strategy, frequently dropping the A-to-B, B-to-C formula for a simple A-to-B, B-to-A round trip.
Assuming both legs of the matched pair cleared, this eliminated the risk of any price difference between the two trades. And that, said FERC, made them improper “wash” trades — transactions that involve no economic risk, no net change in ownership and serve no legitimate business purpose.
FERC had encountered wash trades before. Its investigation of market manipulation in the California and Western energy markets in 2000 and 2001 found that several energy trading companies, including Enron, had engaged in wash trades to create the illusion of liquidity and affect price indices to which contracts are linked. Although the commission then had no regulations on wash trading, such trades were prohibited in markets regulated by the Commodity Futures Trading Commission.
Moving the Market
In their preliminary findings, FERC staff told Chen and Gates that their large trading volumes “adversely affected the whole PJM market.” They cited a discussion between Chen and the other investors in which they acknowledged that their volumes were “moving the market.” A Gates associate complained that “we are trading too much and are bumping up against volume” and suggested they “scale back.”
Between February 2010 and early August 2010 — when PJM asked FERC to approve Tariff changes to close the loophole (ER10-2280) — Chen, Gates and their partners acquired 620,000 MWh eligible for the rebates, turning a $4.7 million profit. The rebates were large enough to cover the scheduling and transmission costs in more than 80% of the hours in which Chen used the identical pair strategy, according to FERC.
Legal Debate
Chen and the partners say their trades were not wash trades because they had a legitimate business purpose: Chen and his investors were making money on the trades.
They also faced the risk that one of the legs might not clear and they would be exposed to the DA-RT price differences. That would occur if the price spread they bet on was too low.
FERC rejects that argument, saying that Chen always bid a spread higher than historical experience for his selected nodes and usually bid at the maximum $50/MWh. The matched trades, FERC said, “never failed to clear.”
FERC’s authority to police market manipulation, which was expanded in the 2005 Energy Policy Act, largely mirrors the Securities and Exchange Commission’s trading rules.
The commission said Chen’s trading was similar to the conduct that the SEC and the Third Circuit Court of Appeals found illegal in the Amanat case, in which a trader seeking to collect rebates based on trading volume used a computer program to enter thousands of sham trades that bought and sold the same securities within a very short time period.
Gates and Chen countered with an affidavit from former SEC attorney Richard Wallace, who said that “trading for the purpose of collecting a rebate is considered a lawful and recognized practice in the securities markets.” When the SEC changed rules to prevent rebate-seeking trading, Wallace said, it did not seek to punish the traders who took advantage of the old rules.
FERC also rejected claims that Chen had no notice that profiting from the rebates alone was improper.
In the 2008 Black Oak Energy case, in which the commission confirmed the basis for PJM’s distribution of the refunds, staff said the commission sought to avoid a market rule in which “arbitrageurs can profit from the volume of their trades.”
Chen’s attorney, John N. Estes III, reads the Black Oak case far differently. In his response to the staff’s preliminary findings, Estes said that while the commission acknowledged the risk of arbitrageurs profiting from trading volume, it never said it was improper to do so.
“To conclude otherwise would fundamentally alter the obligations of market participants,” Estes wrote. “Rather than make decisions consistent with existing price signals, Enforcement’s theory of this case expects them to second-guess whether or not certain aspects of the Commission-approved markets are ‘appropriately’ functioning, and then adjust to their behavior accordingly.”
The investors’ attorneys also said their clients made no attempt to conceal their trading strategy. Thus there was none of the “fraud, artifice or deceit” typical of true market manipulation.
FERC said Chen and Kevin Gates were aware that their trading strategy carried regulatory risk.
“It really concerns me if PJM ever reverts back to those days without [transmission loss credits] or the TLC calculation was/is incorrect and we have to pay back all or some of the TLC refunds, we are going to be in big trouble,” Chen said in a message to Gates.
Gates responded: “[i]f you’re really concerned, then I’m really, really concerned” and suggested they “contact a law firm, the FERC or PJM to try to get more insight into this issue.”
They never did so, FERC says.
Estes said Chen’s trades “added value” to the PJM markets by contributing to price discovery and, “to the extent they caused day-ahead prices to move closer to real-time prices, they promoted market efficiency. They cannot be considered ‘wash’ transactions because they made money and because there was always a nonzero risk that Dr. Chen would be exposed to real-time price spread changes.”
Investigation Begins
FERC began investigating Chen and his partners in August 2010, after being alerted by PJM. Chen had stopped his round-trip trading immediately after receiving a call from PJM Market Monitor Joe Bowring on Aug. 2, 2010.
Over the next three years, Chen and his partners responded to FERC data requests and sat for depositions while their lawyers sparred with FERC’s attorneys and provided affidavits from an economist and an attorney supporting their position.
After one deposition, according to Kevin Gates, a FERC attorney told his lawyer, “He’s a businessman. He should know it’s cheaper to settle than to fight this.”
One company that engaged in similar trades, Oceanside Power, did go that path, agreeing to settle the charges against it by disgorging profits of $29,563 and paying a fine of $51,000 (IN10-5).
But Gates and Chen refused.
In October 2011, FERC said a charging decision was “imminent,” according to William M. McSwain, attorney for the Gates brothers.
FERC did not act, however, until August 2013, when FERC staff delivered a 28-page “preliminary findings” letter summarizing why they thought Chen’s trades were improper. Attorneys for Chen and Gates rejected the arguments and reiterated their demand that FERC end the investigation.
FERC refused.
Gates Goes Public
Frustrated, Kevin Gates began planning a publicity campaign to make the case that he and his partners had been unfairly hounded by FERC.
On Jan. 30, President Obama nominated Bay, then director of FERC’s Office of Enforcement, to fill the seat of former FERC Chairman Jon Wellinghoff.
A month later, Gates went public, launching a website that included much of the correspondence between FERC and the investors’ attorneys and written and video testimonials from an all-star cast including Harvard professor William Hogan and Susan J. Court, Bay’s predecessor as FERC enforcement chief.
FERC critics rallied in support of Gates and Chen, saying the case illustrated the agency’s overzealousness. Former FERC general counsel William Scherman cited the case in a Wall Street Journal op-ed published days before Bay’s Senate confirmation hearing.
FERC Gets More Teeth
When manipulative schemes by traders at Enron and other power marketers roiled the Western energy markets in 2000-01, FERC’s enforcement staff consisted of 20 lawyers in the Office of General Counsel. The maximum penalty FERC could impose was $10,000 per violation per day.
In the 2005 Energy Policy Act, Congress granted FERC expanded authority to police manipulation and increased its maximum penalties to $1 million per violation per day.
FERC’s enforcement unit is now staffed with about 200 economists, accountants, auditors, former traders and attorneys, including former prosecutors.
Under Bay, a former U.S. Attorney, FERC has issued orders demanding more than $1.1 billion in penalties and disgorged profits in market manipulation cases.
At Bay’s Senate confirmation hearing in May, the Gates brothers were sitting in the row behind him. Richard was on camera, over Bay’s shoulder, during the entire two-hour hearing as several Republican senators pressed the nominee to address Scherman’s criticism that Bay was driving Wall Street banks out of energy trading with heavy-handed enforcement tactics.
Bay survived the onslaught and was sworn in last Monday. On Tuesday, FERC issued a “Staff Notice of Alleged Violations,” the commission’s first public acknowledgement of the investigation. Later last week, staff sent the Gateses’ attorney a “1b 19” letter notifying them that staff would recommend the commission seek penalties.
(Although FERC’s preliminary findings challenged $4.7 million in profits the investors made between February and August 2010, the notice issued last week cites only trades made after June 1 on behalf of Chen and the Gateses’ Powhatan Energy Fund.)
De Novo
While most of FERC enforcement cases that become public are quickly settled, Chen and Gates vow that won’t happen in their case. Thus the next step will likely be a commission vote on whether to issue an Order to Show Cause.
If he can’t persuade the commission to drop the case McSwain said, the case will end up in a U.S. District Court.
It would be the third case contested in a de novo court review, joining pending cases involving Barclays bank and Richard Skillman.
Barclays is in federal district court in California, fighting an order that it pay a $453 million fine and disgorge $35 million in unjust profits over alleged manipulation of California and other western power markets. In Maine, energy consultant Richard Silkman is challenging a $1.25 million penalty. One central point of contention is how broad the federal court’s review should be, with FERC arguing for a narrow interpretation. (In addition, BP is challenging a $28 million penalty before a FERC administrative law judge.)
Members of the energy bar say those cases, along with the Chen/Gates case, will help to clarify questions about the limits of the FERC’s expanded enforcement authority.
Their attorneys say Chen and the Gates brothers are looking forward to their day in court.
“If we end up in federal court we start from scratch,” McSwain said in an interview. “It’s the first time we have a neutral decision maker.”
