US FERC emerges as financial crime player with $470 million Barclays penalty

A US regulator with broad enforcement powers levels a large monetary penalty against a big multinational financial institution for illicit transactions and lax compliance. Sound familiar? For more than 25 years since the first Bank Secrecy Act penalty was imposed against Bank of Boston for $500,000, this has been a repetitive scenario.

This time, however, the regulator is not the Office of the Comptroller of the Currency or the FDIC or Federal Reserve or even the Financial Crimes Enforcement Network. It is the Federal Energy Regulatory Commission (FERC), which has entered the financial crime regulatory field with a bang. The once-obscure agency has emerged as a financial crime watchdog supervising the conduct of banks and securities dealers in the multi-billion dollar energy trading field.

On October 31, FERC filed an enforcement order against Barclays that could result in a $470 million penalty if the British institution does not challenge the action in court, as FERC procedures allow. If the penalty stands, it would be the largest ever imposed by FERC.

A FERC “Order to Show Cause and Notice of Proposed Penalty” accuses Barclays and four of its traders of scheming to manipulate US electricity markets and systematically taking losses in certain trades to profit on other investments.

These practices allegedly ran from 2006 to 2008 and earned Barclays an estimated $35 million, but violated FERC anti-manipulation regulations that were promulgated after the Enron scandal of 2005.

FERC cracks down on manipulative trading in energy markets

Barclays is not the only major institution to run afoul of the energy regulator. FERC has taken aim at energy market manipulation in the past two years. It has issued 11 enforcement orders since January 2011 and entered into a $245 million penalty agreement with Constellation Energy Group last March.

In September, FERC issued an enforcement order against Deutsche Bank seeking $1.6 million in penalties for alleged manipulative trading in California energy markets in 2010. The JPMorgan Chase energy trading division is also under FERC investigation for reportedly rigging energy prices in California and Midwest markets.

Before these recent actions, “many [financial institutions] didn’t have an idea who FERC was,” says Susan Court, founder of SJC Energy Consultants, in New Jersey, and former director of FERC’s Office of Enforcement.

“Especially this year, non-traditional energy market actors have become much more aware of FERC,” she adds.

Larger budget and staff let FERC be stronger ‘cop on the beat’

As FERC’s profile has grown, so have its powers to police energy markets. Since 2008, FERC’s Office of Enforcement has more than doubled its budget and augmented its staff with former prosecutors and law enforcement agents. FERC has created a new unit that analyzes and interprets market data to improve detection of suspect trading activity.

“In the past four to five years, FERC has significantly built up its enforcement capability,” says Paul Korman, a partner at Van Ness Feldman, in Washington, DC.  “It has increased its emphasis on enforcement and compliance across all sectors.”

“No one should have ignored FERC,” Korman continues. “If you’re trading in that sector, you should know who the cop on the beat is.”

Enron case led to increased FERC enforcement power

FERC is not a new agency. It was created by the New Deal Federal Power Act of 1934, which established FERC as the primary federal regulator of US electricity and natural gas markets.

“Before 2006, FERC was an economic regulator,” says Court, the former FERC Director of Enforcement. “It’s still primarily an economic regulator – it issues licenses and certificates, sets rates, and approves mergers and acquisitions [of energy companies]. The agency had very minor enforcement authority and almost no penalty authority.”

FERC’s role changed dramatically after Enron’s spectacular collapse. Following revelations of Enron’s widespread gaming of US electricity markets, Congress enacted the Energy Policy Act of 2005. The law authorized creation of FERC’s Office of Enforcement, the promulgation of rules covering manipulative trading practices, and penalties of up to $1 million per day for the duration of each violation.

“Overnight, FERC became an enforcement agency,” says Court. “I don’t know if there’s another agency in the federal government that has both regulatory and enforcement powers to the degree that FERC has.”

FERC order says Barclays gamed markets with ‘uneconomic’ trading

With its new powers, FERC has quietly pursued its enforcement mandate by focusing on electricity market manipulation. It oversees six of the seven US energy trading markets, covering mainly the West coast, Midwest and Northeastern regions.

In the 73-page order against Barclays, FERC targets trading in Western markets and alleges that the institution’s traders colluded to influence prices in wholesale electricity, or the “physical” market. FERC alleges that the bank’s self-dealing sought to improve its position on financial swaps tied to electricity prices. FERC began investigating Barclays in 2007 after being tipped off by other market participants, according to the order.

The trades on the physical market were “not intended to get the best price on those transactions,” the order says. Barclays allegedly took losses on more than half of its physical trades in order to reap a large profit on the swaps market. FERC says this manipulation “caused losses to market participants estimated at $139.3 million.”

In addition to the $470 million penalty on Barclays, the order levies $1 million penalties against three of the bank’s traders and $15 million in penalties against the alleged ringleader of the electricity market rigging, Scott Connelly, Managing Director of Barclays’ US electricity trading operation.

E-mails and data analysis were crucial in FERC’s Barclays probe

If Barclays challenges the FERC enforcement action, the agency must demonstrate that the bank knowingly engaged in “uneconomic trades” to manipulate electricity markets, or acted with “reckless disregard” of the regulations. Key pieces of evidence for FERC are the e-mails and instant messages among Barclays employees. They depict the traders using vulgar terms to boast about the rigged prices.

In an instant message detailed in the order, one trader said “he was ‘doing phys[ical] so I am trying to drive price in fin[ancial] direction.’” Another email described how he rigged “‘the… market.’” In other messages, the traders discussed how they “crapped on” physical markets to boost prices for financial swaps.

The messages cited in the order are evidence of FERC’s increased focus on capturing electronic data, says Court. “These cases are remarkably data-intensive. Communications had to be sorted and interpreted to find damaging evidence, along with huge amounts of market data.”

Earlier this year, FERC created the Division of Analytics and Surveillance in the Office of Enforcement to hone its data gathering and analysis capabilities.

FERC report also cited poor compliance at Barclays

FERC also cited Barclays “inadequate” compliance controls in its electricity trading operations. It said “Barclays did not have systems in place to detect [trading issues].”

It added that Barclays’ Commodities Compliance department missed “opportunities to uncover the… manipulation” and failed to investigate a trader’s conduct after another Barclays employee reported suspicious trades.

Barclays and its traders have 30 days to respond. The bank has issued a statement saying its “trading was legitimate and aboveboard” and that it would “vigorously defend this matter.”

With more enforcement actions likely, institutions mull fight with FERC

Barclays may resist the enforcement order in several ways, including a challenge before an administrative law judge. It may also refuse to pay the assessed penalty, which would send the case to trial in a US District Court.

Given the scant legal precedent in FERC enforcement actions, institutions may be more willing to risk a court battle. Deutsche Bank is already taking a combative stance, saying that FERC’s enforcement order contains a “legal position… (that) is radical” and threatening a trial.

“If the commission does not abandon these deeply flawed allegations now, they will be overturned by a federal district court,” said Deutsche Bank in a November 6 response to FERC order.

Regardless of the outcome of the current enforcement actions, institutions should expect more from FERC in the pipeline, says Court.

“Given the amount of time these cases take to investigate, it’s not surprising we’re seeing them now,” Court notes. “I would be very surprised if there’s not more to come.”

View the Barclays enforcement order here