Identifying and Managing Legal Risk Post-Enron

1. Identifying and Managing Legal Risk Post-Enron by Andrea S. Kramer Partner McDermott, Will & Emery <akramer@mwe.com> Futures Industry Association Expo November 7, 2002

2. Various Ways to Manage Risk • Hedging activities • Insurance • Diversification and entry and exit strategies • State-of-the-art contracts, policies, and procedures • Tax compliance (federal and state) • Regulatory compliance (federal and state) • Securitizations and hybrid products

3. Risk Management “Risk management tools have emerged to help market participants protect themselves against uncertain price movements. Wholesale electric power markets, while still developing, are beginning to look like markets for other commodities.” – FERC Staff Report, 1998

4. Board of DirectorsResponsibilities • Clearly establish overall risk philosophy • Approve risk management policies and procedures • Support management needs for technical capacities • Evaluate risk management performance • Oversee risk management activities • designate and delegate various responsibilities • risk management committee

5. Types of Risks to Address • Market Risk — the loss in market value of a position due to unexpected changes before position can be liquidated or offset • Credit Risk — the risk a counterparty is unable to meet its obligations or make payments when due

6. Types of Risks to Address(Cont’d) • Liquidity Risk • market risk: can’t easily unwind or offset positions • funding risk: unable to meet payment obligations when due (such as margin calls) • Operational Risk — Losses due to inadequate systems, internal controls, human error, or management failure • Legal Risk — Losses due to unenforceability of a contract, incorrect documentation, or unexpected tax consequences

7. Risks Not Easily Measured • Operational Risk • Legal Risk

8. Risk ManagementOperations • Trading authorizations, approvals, limits, and guidelines • Approval of new products • Monitoring operations

9. Risk ManagementAdministration • Master agreements and netting agreements • Scheduling procedures • Settlement procedures • Computer tracking

10. Avoid Trading Surprises • Set out trading authority and responsibilities • Proper performance reviews and appropriate compensation packages • Employee screening and background checks • Careful and ongoing monitoring to watch for • trading authority and responsibilities • trading model failure • trading deceptions • Front, Middle, and Back Office discrepancies

11. Warning Signals to Prevent Trader Deception • Must understand and listen to warning signals to avoid surprises • Need to distinguish between warning signals and “trader talk” • What may be a warning signal in one situation can be just “trader talk” in another situation

12. Adequate Compliance Programs • Develop company-wide culture to support internal controls • Senior management must support compliance efforts • There must be adequate staffing and resources to perform all compliance functions

13. Adopt Ethics Codes • Identify appropriate general conduct • Provide “aspirational” Codes that express business aims and intent • Evaluate behavior and transactions as “right” and “appropriate” • Require employees to acknowledge compliance with the Ethics Code

14. Compliance Culture and Behavior • Senior management supports the Ethics Code • Communicate and reinforce ethical culture throughout company • Train employees • Establish and enforce ethical values • Conduct annual and spot compliance audits

15. Employee Acknowledgements • Received, read, and understand employee’s responsibilities • Will conduct activities consistent with terms, philosophy, and spirit of all policies and procedures • Will comply with all conflict of interest policies • Will protect confidential and proprietary information • All conversations will be conducted on recorded lines, which may be monitored and taped

16. Corporate Sentencing Guideline Requirements • Standards and procedures “reasonably capable” of preventing criminal conduct • Oversight by high-level personnel • Careful delegation of discretionary authority • Effective communication to all employees • Reasonable steps taken to assure compliance • Enforce disciplinary mechanisms • Respond if an offense is detected

17. New Corporate Reform Regulation • Proposed Revised NYSE Corporate Governance Standards • Sarbanes-Oxley Act of 2002 • SEC Rulemaking

18. NYSE Listing Requirements • Pending rule changes will substantially raise corporate governance standards • Mandating “best practices” for all listed companies • Requires shareholders to vote on equity-compensation plans

19. Sarbanes-Oxley • Public companies • Officers and directors • Employees • Auditors • Investment bankers • Attorneys

20. Sarbanes-OxleySummary • CEO/CFO Certification • More “real-time” disclosure of events • Audit committee • Auditor independence • Accelerated Section 16 reporting • Retirement fund “blackout periods” • Prohibit loans to executive officers and directors

21. Sarbanes-OxleyLoan Prohibition • Broad blanket prohibition with limited exceptions • Material modifications not allowed to existing loans • May cover many compensatory agreements • SEC guidance unlikely anytime soon

22. Corporate GovernanceDirectors Duties Have Not Changed • Directors have fiduciary duties to stockholders • Company must be run for the benefit of the stockholders • Duty of Loyalty — must act in best interests of the company, free from conflict with personal, financial, or other interests • Duty of Care — must make decisions on an informed basis — which requires oversight of risk management and legal compliance programs

23. Corporate GovernanceBusiness Judgment Rule • Actions taken in good faith and on an informed basis are usually protected from judicial scrutiny and second-guessing • Courts will not substitute their business judgment for the judgment of the Board acting without self-interest; but lack of self-dealing must be carefully documented

24. Corporate GovernanceActing on an Informed Basis • Directors need to probe and understand information and transactions under consideration • Board micro-management is not required — but if in doubt, Board should ask questions • Directors can rely on internal reports (including financial) if presented by employees reasonably believed to be reliable • Directors can rely on reports by outside advisors reasonably believed to be qualified

25. Corporate GovernanceActing on an Informed Basis - Practical Advice • Directors must understand the operations, profit model, and strategy of the company • Management team must be committed to provide and update this information • Directors must study the information provided and ask penetrating questions — no “rubberstamping”

26. Corporate GovernanceActing on an Informed Basis - Practical Advice • Corporate governance guidelines — prepares the Board for critical action by establishing policies • Review basics (Board composition, setting agenda items, handling Board materials, and attendance of non-directors at meetings) • Typically deals with holding Board meetings without the CEO or management, selection of a Director to lead such meetings, evaluation of the CEO, and succession planning

27. Corporate GovernanceActing on an Informed Basis - Practical Advice • Orientation program for new directors (meeting the CEO, the CFO, the heads of the key business units, the general counsel and the auditor) • Directors manual — a handy reference guide for each director with key information and company documents • Directors should regularly get copies of media coverage and the analyst reports on the company

28. Corporate GovernanceBottom Line • Corporate reform regulation raises the bar for Directors in fulfilling their duties, forcing a return to fundamentals • Directors who do not comply with increased standards and heightened stockholders expectations face increased liability for breach of duty

29. Sarbanes-OxleyCode of Business Conduct and Ethics • Listed companies will be required to have and publicly disclose a Code of Business Conduct and Ethics, as well as a separate Code of Ethics for Senior Financial Officers, and must also disclose any subsequent changes or waivers to such codes • Code of Conduct and Ethics policies currently in place may need refinement, with new financial executives code established once relevant NYSE and SEC rules are finalized

30. Sarbanes-OxleyWhistleblower Protection • Companies cannot discriminate against employees who assist investigations of securities law violations • Audit committees must, subject to future SEC rules, establish procedures: • for handling complaints regarding accounting or auditing matters, and • for employees to submit confidential, anonymous concerns regarding questionable practices

31. Causes of Legal Risk • Inadequate documentation (unintended consequences) • Counterparty lacks authority • Transaction not permitted by applicable law • Insolvency laws limit or alter contractual remedies • Unintended tax consequences

32. Legal Review • Counterparty capacity • Counterparty authority • Periodic review of agreements to update for legal and market practice developments • Customer appropriateness • Tax compliance

33. Contract TermsPlanning and Preparation • Understand terms of contracts • Are there liquidated damage provisions? • Are there curtailment provisions for firm transactions? • What is emergency power, and under what conditions is it sold?

34. Why Documentation Is Critical • Enforceability and the statute of frauds • does the UCC apply • Qualified Financial Contracts • Activation of the material provisions • Bankruptcy and insolvency protections

35. Documentation Considerations • Representations and warranties • Force majeure • Netting provisions • payments • delivery obligations • Setoff provisions • Events of default

36. Counterparty Appropriateness • Counterparty sophistication • Counterparty needs • Transaction complexity • Maintain contact with counterparty’s senior management • Avoid counterparty confrontations

37. Typical Contracts • Swaps • Caps • Floors • Collars • Options • Futures contracts

38. Documentation • Master Agreement • recognized master agreement • homegrown master agreement • Netting Agreement • cross-product master netting agreement • homegrown netting agreement • Futures Contracts

39. Connecting The Documentation Pieces • Master Agreement • Schedule (or letter agreement with general business terms) • Confirmations (with specific deal terms) • Credit Support Documents

40. Legal and Risk Issues • Designate principal contact persons • Confirm counterparty authority • Obtain consent to recording • Analyze credit risk • Provide traders with guidelines • Confirmations

41. Guidelines • Senior management must understand products and their consequences • Consider purposes and types of transactions • Establish counterparty limits reflecting credit issues and underlying economics • Develop standard master agreements • Provide for netting, set-off, and unwind provisions • Monitor compliance with policies, procedures, and controls

42. Preparation of Company Documents • Lawful conduct can become suspect • Avoid poor word choices and ambiguous expressions • Avoid careless or inappropriate language in company communications • Avoid “guilt” words (“Please destroy after reading”) • Avoid exaggerated use of power words (“This program will ‘destroy’ our competition”) • Use care when discussing competition and prices

43. Beware: Communications Are Not Secret or Confidential • Common sources of damning evidence • Xerox copies, telephone recorders, e-mail, phone-mail, PC disks, e-calendars, and pocket diaries • All electronic data, including system databases, system activity logs, word processing files, and transaction data • Business expressions and marketing terms can appear suspect in a courtroom

44. Brief Focus onEnergy Markets

45. Regulatory Considerations • Once a product or practice is identified, is it permissible? • corporate authorizations, policies, and procedures? • compliance with state laws? • Is the product regulated by the FERC? • Is the product regulated by the CFTC or SEC? • Any other regulation? PUC or state insurance commissions? • If regulated, are there limitations on trading?

46. CFTC Jurisdiction • Exclusive jurisdiction over futures contracts • Limited jurisdiction over certain forward contracts of a cash commodity for deferred shipment or delivery (fraud or manipulation) • Limited jurisdiction over certain spot transactions (fraud or manipulation)

47. Price Manipulation • Overlap between FERC and CFTC • Potential conflicts over standards used to determine if there has been manipulation • FERC will follow CFTC’s definition in Enron investigation

48. The Commodity Exchange ActManipulation Violations • Wrongdoer must have the ability to influence market prices • Wrongdoer must specifically intend to create an artificial price • The price of the commodity must be artificial • Wrongdoer must have caused the artificial price

49. Competition LawDo’s and Dont’s • Trading activities • dealing with competitors • bidding • pricing • Involvement in associations and group organizations • Documents

50. Trading ActivitiesDealing With Competitors • Price-fixing in forward markets and real time markets • bilateral contracts issues • day of, day ahead, hour ahead issues • real time imbalance market issues • 1998 Midwest Price Spike – FERC found a likelihood of conspiracy to send false signals to the market