Hedge Fund Twins Stage Campaign Against Energy Regulator

Norman Bay, the top sheriff of U.S. energy markets, has taken on giants, imposing more than $881 million in combined fines on Barclays (BARC) Plc, JPMorgan Chase & Co. and Deutsche Bank (DB) AG over alleged price manipulation.

Now, Bay is the target. A small Pennsylvania hedge fund has taken up Wall Street’s cause and embarked on a public campaign to stop the former prosecutor from being confirmed as the next chairman of the Federal Energy Regulatory Commission.

Powhatan Energy Fund LLC, under investigation for rigging a power-hub market, started a website to argue that the firm is being wrongly targeted and that the agency, under Bay’s leadership as enforcement director, is going too far. His rise to the FERC’s top job would cement the agency’s decade-long transformation from a sleepy regulator with a soft touch to an aggressive enforcer doling out steep penalties. He would be the first former federal prosecutor to hold the post.

“The government wields tremendous power when they swing around the charge of market manipulation,” Rich Gates, who runs the fund, said in an interview. Going public “was an insurance policy against our personal and professional reputations,” said Kevin Gates, Rich’s identical twin who also manages Powhatan.

William McSwain, a lawyer for Powhatan at Drinker Biddle & Reath LLP, said they’re lobbying to block Bay’s nomination.

“We’re out there actively trying to talk to senators and staffers about our story and spreading the word about the website and trying to get his nomination defeated,” McSwain said in an interview.

Bolstered Enforcement

Bay, 53, declined to comment through a FERC spokeswoman, Mary O’Driscoll. O’Driscoll said the agency can’t confirm or deny an investigation is under way.

Bay, a former U.S. Attorney in New Mexico during the Clinton administration, joined the FERC as enforcement director in July 2009 as part of former Chairman Jon Wellinghoff’s efforts to bolster the agency’s market-policing ability.

Under Wellinghoff, the FERC expanded its enforcement office to about 200 people, adding a former general counsel for the Federal Bureau of Investigation and about 40 analysts who focus on market-manipulation violations.

Obama said Jan. 30 he would nominate Bay to be chairman of the five-person commission. The Senate Energy and Natural Resources Committee still hasn’t scheduled his confirmation hearing, leaving the FERC’s leadership in limbo. Ron Binz, Obama’s previous nominee, withdrew from consideration Sept. 30 after failing to win the support of key lawmakers. Commissioner Cheryl LaFleur is acting chairman.

Evidence Found

Powhatan, one of its traders and three related funds are being investigated for trades in PJM Interconnection LLC’s energy market, which spans the Mid-Atlantic and parts of the Midwest, that made $4.7 million in profits over at least six months in 2010, according to documents made public by the hedge fund. Under the law, the FERC can impose a civil penalty of as much as $1 million per day for each violation. Agency staff in August notified Powhatan that it found evidence of manipulation, according to documents posted on the website.

According to the hedge fund, the trading practices in question are legal and akin to the high-frequency trading that now accounts for more than 50 percent of all trading volume in the U.S. equities market. The practice involves placing trades that generate little or no profit other than a rebate offered by the market.

Rebate Loophole

The FERC alleged that Powhatan trader Alan Chen gamed the PJM market in 2010 by trading power hubs only to receive rebates. PJM operates the largest U.S. competitive power market by serving more than 61 million people in 13 states from Delaware to Illinois.

That year, all traders had to make upfront payments to reserve transmission access to sell electricity on the grid. About 2 percent to 4 percent could be lost as the electricity flowed through power lines. So, those traders would be paid a rebate to compensate them for the lost energy. At the time, the refund was nearly twice as much as the transmission cost.

That made it profitable for hedge funds to trade energy between hubs that were physically close to each other even if the differences in price were negligible. FERC shut down the practice in September 2010 in response to a PJM proposal, saying in an order it wanted to “ensure that parties are not engaged in transmission transactions solely because the marginal line loss credit exceeds the cost of entering into those transactions.”

FERC ‘Misguided’

The hedge fund is being unfairly penalized for profiting from a loophole in the FERC’s rules, McSwain, Powhatan’s lawyer, said in the interview.

Susan Court, Bay’s immediate predecessor at FERC, said the agency is taking enforcement too far and using it to set policy and create new market-manipulation law.

Court, who now runs SJC Energy Consultants LLC and was paid by the Gates brothers to review the case, said Powhatan wasn’t trying to conceal its strategy, indicating the conduct wasn’t illegal. “It was all very transparent,” she said.

William Hogan, a professor of global energy policy at Harvard University, wrote a paper backing Powhatan. Hogan, who was paid by the hedge fund to do the paper, said in an interview that the FERC has been empowered by enormous settlements that may have no legal basis yet go unchallenged as companies sign off without admitting or denying the alleged behavior -- and in some cases leave the market entirely.

“I think they’re misguided and overstepping in some of these cases,” Hogan said. “I don’t think the commissioners themselves know what’s going on. They see the settlements and only get one side of the story.”

High Stakes

The stakes are high. Frankfurt-based Deutsche Bank announced plans to exit trading in energy and other commodities after reaching a settlement with FERC in January 2013. JPMorgan (JPM), which was also under pressure from the Federal Reserve, has agreed to sell its physical commodities business as well. Its high-profile leader, Blythe Masters, is resigning from JPMorgan once the deal is completed.

Marc Spitzer, a former commissioner who was with the agency when the Powhatan trades occurred, said the FERC is doing exactly what it’s supposed to do, after Congress expanded the agency’s enforcement authority in 2005 in response to rolling blackouts in California.

“FERC, I don’t think, is doing anything out of the ordinary,” Spitzer, who is now a partner at Steptoe & Johnson LLP in Washington, said in an interview. “This entity jumped the gun” by trying to get ahead of the FERC adjudication process, he said.

‘Flash Boys’

Bay’s enforcement unit doesn’t always get its way. Last year, a federal court threw out a $30 million manipulation fine against Brian Hunter, a former natural-gas trader for Amaranth Advisors LLC, telling the agency it lacked authority over futures contracts.

London-based Barclays is fighting a $470 million penalty levied against the bank in July for manipulation.

Kevin and Rich Gates, 42, are chemical engineering graduates of the University of Virginia who started money management firm TFS Capital LLC in 1997. The firm isn’t related to Powhatan and manages about $1 billion in long-short funds for retail investors.

Rich Gates is mentioned in Michael Lewis’ “Flash Boys” book as a person who had gone to the U.S. Securities and Exchange Commission claiming that certain dark pools were being rigged after running several tests in 2010 involving he and his colleagues’ money.

‘Wash Trade’

The brothers said they started trading power markets a year before meeting Chen, an energy trader with a doctorate in electrical engineering, in 2008.

Regulators contend Chen “designed and scheduled” PJM transactions that “had the same effect as what the law would label a ‘wash trade’ or ‘sham’ transaction,” according to a FERC report from August made public by Powhatan.

If FERC finds that Powhatan did something wrong then the agency would issue a notice of alleged violation, which is usually the first public notice of a case.

Chen initially made these trades through his own funds and another called Huntrise Energy Fund LLC, which was managed by the Gates brothers. In May 2010, Powhatan, which has about 10 investors, was created as the vehicle for Chen to trade in the PJM market, according to FERC documents on the website.

Red Flags

“The facts show that Chen intended to engage in sham trades whose profits derived not from changes in market prices but from taking advantage” of the rebate program, Steven Tabackman, FERC’s lawyer, wrote in an Aug. 9 report.

John Estes III, Chen’s lawyer at Skadden, Arps, Slate, Meagher & Flom LLP in Washington, didn’t return calls seeking comment.

Frank Wolak, an economics professor at Stanford University who focuses on energy-market competition, said the FERC is signaling that market participants have a duty to report loopholes in market rules to regulators and grid operators instead of exploiting them for profit.

“Electricity is essential to the modern economy, and maybe we do put more obligations on market participants,” said Wolak, who isn’t involved in the Powhatan case.

If that’s the case, federal regulators should create a protocol for traders to raise red flags instead of issuing fines before clarifying the rules, he said.

“We’re going to see an adjustment from the market in that they’re not just going to roll over on every investigation,” said Brian Heslin, a lawyer at Moore & Van Allen Pllc who represents companies and utilities in the energy sector and isn’t involved in the Powhatan case. “To the extent that FERC’s kind of getting out of their comfort zone, you’re going to see more and more folks willing to push them to win it.”

To contact the reporters on this story: Tom Schoenberg in Washington at tschoenberg@bloomberg.net; Brian Wingfield in Washington at bwingfield3@bloomberg.net; Naureen S. Malik in New York at nmalik28@bloomberg.net

To contact the editors responsible for this story: Sara Forden at sforden@bloomberg.net Joshua Gallu, Jesse Westbrook

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