OVERVIEW OF ENERGY TRADING ISSUES

1. 1 OVERVIEW OF ENERGY TRADING ISSUES Peggy A. Heeg Partner, Fulbright & Jaworski L.L.P. Global Energy Management Institute UH-GEMI 3rd Annual Energy Trading and Marketing Conference: Rebuilding the Business January 20, 2005 I am going to talk about three trading topics. It is worth noting that just a few years ago these topics wouldn�t have been on anyone�s radar screen for a possible discussion topic at an energy trading conference. These topics are an indication of how much the California energy crisis and the implosion of the trading business have fundamentally changed the trading business. I am going to talk about: FERC regulation of the trading business. CFTC jurisdiction over trading business. And if that is not enough, the criminal prosecution of energy traders. I am going to talk about three trading topics. It is worth noting that just a few years ago these topics wouldn�t have been on anyone�s radar screen for a possible discussion topic at an energy trading conference. These topics are an indication of how much the California energy crisis and the implosion of the trading business have fundamentally changed the trading business. I am going to talk about: FERC regulation of the trading business. CFTC jurisdiction over trading business. And if that is not enough, the criminal prosecution of energy traders.

2. 2 FERC Market Behavior Rules Peggy A. Heeg Partner, Fulbright & Jaworski L.L.P. January 20, 2005 I am going to start with the FERC. With the adoption of market behavior rules a little over a year ago. And although these rules have not gotten much attention, there is no doubt that FERC has aggressively asserted jurisdiction over trading companies. Particularly troubling is the fact that the rules are extremely broad, intentionally vague and give the FERC a lot of room to state that any type of behavior violates the rules. I predict that when the next hiccup in the market occurs -- like the California energy crisis � the FERC will use these rules aggressively against traders.I am going to start with the FERC. With the adoption of market behavior rules a little over a year ago. And although these rules have not gotten much attention, there is no doubt that FERC has aggressively asserted jurisdiction over trading companies. Particularly troubling is the fact that the rules are extremely broad, intentionally vague and give the FERC a lot of room to state that any type of behavior violates the rules. I predict that when the next hiccup in the market occurs -- like the California energy crisis � the FERC will use these rules aggressively against traders.

3. 3 FERC 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. So how did the market behavior rules come about? Quite some time after the California energy crisis and the implosion of Enron, FERC initiated a study of how trading strategies impacted the California crisis. The investigation quickly turned into an investigation of all trading activities generally. The report following FERC�s investigation, which is several hundred pages long, and in my opinion a plaintiff�s lawyer�s dream, is an indictment of trading. As you will see from this slide, FERC concluded that everyone was reporting false price information and that rapid fire trading, wash trades and economic withholding distorted prices in the western U.S.So how did the market behavior rules come about? Quite some time after the California energy crisis and the implosion of Enron, FERC initiated a study of how trading strategies impacted the California crisis. The investigation quickly turned into an investigation of all trading activities generally. The report following FERC�s investigation, which is several hundred pages long, and in my opinion a plaintiff�s lawyer�s dream, is an indictment of trading. As you will see from this slide, FERC concluded that everyone was reporting false price information and that rapid fire trading, wash trades and economic withholding distorted prices in the western U.S.

4. 4 The 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. In response, FERC issued two rules -- one for gas and one for electricity. The gas and electricity rules are very similar.In response, FERC issued two rules -- one for gas and one for electricity. The gas and electricity rules are very similar.

5. 5 FERC Market Behavior RulesMarket 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. Both rules prohibit market manipulation . This is a very scary rule in that it prohibits transactions without a legitimate business purpose or activities that could foreseeably manipulate market prices or conditions. This language is so broad that you could fit almost any type of activity within this definition. If we have another California energy crisis, you can just imagine how parties will argue that trading activities violated this vague rule.Both rules prohibit market manipulation . This is a very scary rule in that it prohibits transactions without a legitimate business purpose or activities that could foreseeably manipulate market prices or conditions. This language is so broad that you could fit almost any type of activity within this definition. If we have another California energy crisis, you can just imagine how parties will argue that trading activities violated this vague rule.

6. 6 FERC Market Behavior RulesMarket 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. Most troubling is that FERC crafted the rules in an intentionally vague matter. FERC declined to define what is a �legitimate business purpose�. Most troubling is that FERC crafted the rules in an intentionally vague matter. FERC declined to define what is a �legitimate business purpose�.

7. 7 FERC Market Behavior RulesMarket 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. FERC did give examples of the types of activities that are prohibited. But FERC is clear the prohibited activities are not limited to those on the list. Specifically: - wash trades; - reporting of false information to transmission providers; - the creation of artificial congestion; and -collusion with other parties is precluded.FERC did give examples of the types of activities that are prohibited. But FERC is clear the prohibited activities are not limited to those on the list. Specifically: - wash trades; - reporting of false information to transmission providers; - the creation of artificial congestion; and -collusion with other parties is precluded.

8. 8 FERC Market Behavior RulesReporting 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. The rule also provides that to the extent the seller submits price information to trade indices, the seller shall provide correct information.The rule also provides that to the extent the seller submits price information to trade indices, the seller shall provide correct information.

9. 9 FERC Market Behavior RulesRecord 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. The market behavior rules also impose a three year record retention obligation. The obligation is very broad and requires traders to keep all documentation upon which it billed customers beginning with the inception of the transaction. The market behavior rules also impose a three year record retention obligation. The obligation is very broad and requires traders to keep all documentation upon which it billed customers beginning with the inception of the transaction.

10. 10 FERC 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).� On rehearing the FERC stated that it was not going to distinguish between primary and secondary documents and clarified that the content of the document, not the medium controls. If you haven�t already done so, you should make sure your document retention policies, including tape recordings, are designed to meet this requirement. On rehearing the FERC stated that it was not going to distinguish between primary and secondary documents and clarified that the content of the document, not the medium controls. If you haven�t already done so, you should make sure your document retention policies, including tape recordings, are designed to meet this requirement.

11. 11 Procedural 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. The rules do provide some procedural protections regarding timing of complaints and Commission action.The rules do provide some procedural protections regarding timing of complaints and Commission action.

12. 12 Consequences of Violating the Market Behavior 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. To date, there have been no enforcement actions or orders interpreting the rules. You should take little comfort from this. These rules remind me of the FERC�s marketing affiliate rules. FERC adopted vague marketing affiliate rules and didn�t take any action for several years and then began to hammer companies. I am confident that FERC will aggressively use these rules when there is a hiccup in the market and the remedies can be severe: - disgorgement of profits; - revocation of market based rate authority; and - other appropriate remedies. And it is worth reminding ourselves that FERC is part of the President�s Corporate Fraud Task Force.To date, there have been no enforcement actions or orders interpreting the rules. You should take little comfort from this. These rules remind me of the FERC�s marketing affiliate rules. FERC adopted vague marketing affiliate rules and didn�t take any action for several years and then began to hammer companies. I am confident that FERC will aggressively use these rules when there is a hiccup in the market and the remedies can be severe: - disgorgement of profits; - revocation of market based rate authority; and - other appropriate remedies. And it is worth reminding ourselves that FERC is part of the President�s Corporate Fraud Task Force.

13. 13 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 In sum, whether you want to admit it or not, FERC has asserted jurisdiction over trading companies. I suggest that you should take the rules seriously. Given the broad and deliberately vague nature of the rules, companies should establish detailed compliance procedures and education programs. You should also know that FERC has staffed up its market monitoring group and has hired x-traders to help it understand market manipulation strategies.In sum, whether you want to admit it or not, FERC has asserted jurisdiction over trading companies. I suggest that you should take the rules seriously. Given the broad and deliberately vague nature of the rules, companies should establish detailed compliance procedures and education programs. You should also know that FERC has staffed up its market monitoring group and has hired x-traders to help it understand market manipulation strategies.

14. 14 Commodity Futures Trading Commission Turning now to the Commodity Futures Trading Commission (CFTC). A few years ago the CFTC was a sleepy little agency that most energy traders didn�t even know existed.Turning now to the Commodity Futures Trading Commission (CFTC). A few years ago the CFTC was a sleepy little agency that most energy traders didn�t even know existed.

15. 15 Commodity 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. Coming under criticism as a result of the California energy crisis and Enron, the CFTC has recently become much more aggressive. The CFTC has investigated over 40 energy companies and has entered into settlements with 20 energy companies with penalties totaling over a quarter billion dollars. Coming under criticism as a result of the California energy crisis and Enron, the CFTC has recently become much more aggressive. The CFTC has investigated over 40 energy companies and has entered into settlements with 20 energy companies with penalties totaling over a quarter billion dollars.

16. 16 Commodity 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. The cases have been brought under the Commodity Exchange Act which was enacted in 1922. The CFTC is using its broad authority under the Commodity Exchange Act to go after energy companies. Prior to 2003, the CFTC had not brought a market manipulation case against an energy company. The cases have been brought under the Commodity Exchange Act which was enacted in 1922. The CFTC is using its broad authority under the Commodity Exchange Act to go after energy companies. Prior to 2003, the CFTC had not brought a market manipulation case against an energy company.

17. 17 Commodity 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.� The Commodity Exchange Act is one of those scary statutes in that it�s worded so broadly that you don�t know what it means. Let�s look at the language. It is unlawful to �attempt to manipulate� (whether you are successful or not) the price of any commodity or cause to be delivered false or misleading reports concerning market information that affects or �tends� to affect prices. I submit that you can go on any company�s stock message board and find individuals violating this statute on a daily basis.The Commodity Exchange Act is one of those scary statutes in that it�s worded so broadly that you don�t know what it means. Let�s look at the language. It is unlawful to �attempt to manipulate� (whether you are successful or not) the price of any commodity or cause to be delivered false or misleading reports concerning market information that affects or �tends� to affect prices. I submit that you can go on any company�s stock message board and find individuals violating this statute on a daily basis.

18. 18 Commodity 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. The CFTC and FERC have recently teamed up to monitor energy markets. The good news is that their first joint investigation of price movements in late 2003, concluded that price movements were a result of market forces and not market manipulation.The CFTC and FERC have recently teamed up to monitor energy markets. The good news is that their first joint investigation of price movements in late 2003, concluded that price movements were a result of market forces and not market manipulation.

19. 19 Commodity Futures Trading Commission Cooperation Advisory Outlines factors that CFTC will weigh in evaluating whether a company has cooperated with the CFTC. Factors include: I want to turn now to the recently issued CFTC Cooperation Advisory which can be found on the CFTC website. This is a very scary document. As everyone knows that has been in the energy business over the past few years, the justice department and the SEC have issued statements of what it means to cooperate with a government investigation. These statements are important because agencies often decide whether to prosecute a company, as opposed to individuals, based on whether the company has cooperated with the agency. This fall the CFTC issued its cooperation advisory. The CFTC�s definition of cooperation goes beyond any other agency. The CFTC expects companies to prosecute themselves. It is also worth noting that the 20 energy companies that have entered into settlements with the CFTC have an ongoing cooperation obligation.I want to turn now to the recently issued CFTC Cooperation Advisory which can be found on the CFTC website. This is a very scary document. As everyone knows that has been in the energy business over the past few years, the justice department and the SEC have issued statements of what it means to cooperate with a government investigation. These statements are important because agencies often decide whether to prosecute a company, as opposed to individuals, based on whether the company has cooperated with the agency. This fall the CFTC issued its cooperation advisory. The CFTC�s definition of cooperation goes beyond any other agency. The CFTC expects companies to prosecute themselves. It is also worth noting that the 20 energy companies that have entered into settlements with the CFTC have an ongoing cooperation obligation.

20. 20 False 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. Turning to false reporting to the indices, the CFTC has concluded that false price reporting was widespread and in many cases blatant. For example, one company maintained an Inside FERC bogus spreadsheets. Other companies had open dialogue about reporting to the book bias.Turning to false reporting to the indices, the CFTC has concluded that false price reporting was widespread and in many cases blatant. For example, one company maintained an Inside FERC bogus spreadsheets. Other companies had open dialogue about reporting to the book bias.

21. 21 Criminal 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. Which leads us to criminal prosecution of traders. Traders for Duke, Dynegy, El Paso, Reliant and Williams have been indicted (and I am sure I am missing some). Most of the indictments have been under the CEA for reporting false price information and/or market manipulation through wash trades or manipulative trading startegies. Some of the most recent charges have alleged a conspiracy to manipulate the market.Which leads us to criminal prosecution of traders. Traders for Duke, Dynegy, El Paso, Reliant and Williams have been indicted (and I am sure I am missing some). Most of the indictments have been under the CEA for reporting false price information and/or market manipulation through wash trades or manipulative trading startegies. Some of the most recent charges have alleged a conspiracy to manipulate the market.

22. 22 Criminal 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. Two very recent activities that you should take note of � first, a Williams trader in a plea agreement stated that he knew reporting false pricing information could benefit his trading position and that it did benefit his trade position. Second, recent indictments allege conspiracy among traders in different companies to manipulate prices through false reporting. These two events may signal trouble for companies in civil litigation. Most notably there is litigation in federal court in New York regarding price reporting in which most energy companies have been named. The Plaintiffs in this case recently had a major victory by surviving motions to dismiss. Although it will be very difficult for plaintiff�s lawyers to prove damages as a result of false price reporting, these recent events are troubling and this is definitely litigation to watch.Two very recent activities that you should take note of � first, a Williams trader in a plea agreement stated that he knew reporting false pricing information could benefit his trading position and that it did benefit his trade position. Second, recent indictments allege conspiracy among traders in different companies to manipulate prices through false reporting. These two events may signal trouble for companies in civil litigation. Most notably there is litigation in federal court in New York regarding price reporting in which most energy companies have been named. The Plaintiffs in this case recently had a major victory by surviving motions to dismiss. Although it will be very difficult for plaintiff�s lawyers to prove damages as a result of false price reporting, these recent events are troubling and this is definitely litigation to watch.

23. 23 CRIMINAL PROCEEDINGS AGAINST INDIVIDUALS 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. With respect to the criminal indictments for false price reporting, the Fifth Circuit ruled last month that the Commodity Exchange Act is not unconstitutionally overbroad.With respect to the criminal indictments for false price reporting, the Fifth Circuit ruled last month that the Commodity Exchange Act is not unconstitutionally overbroad.

24. 24 For More Information Please contact: Peggy A. Heeg (713) 651-8443 pheeg@fulbright.com