The Investors at War With Political Power

Rather long, but folks – we need to start paying attention to “the government of ours’ which ‘managers’ of which are more and more thinking they can do as they wish.
How a once-obscure federal agency targeted two brothers, and what happened when they decided to fight back in the age of Obama.
By JOSEPH RAGO CONNECT May 2, 2014 6:45 p.m. ET West Chester, Pa.

There’s a quote hanging on the wall of Rich Gates’s office, here in a suburb west of Philadelphia: “No person, in any culture, likes to be bullied. No person likes living in fear because his or her ideas are different. Nobody likes being poor or hungry, and nobody likes to live under an economic system in which the fruits of his or her labor go unrewarded.” President Obama, in his book “The Audacity of Hope,” meant those words as inspirational; for Mr. Gates, they are ironic.

Late last summer Mr. Gates and his identical-twin brother, Kevin, learned in a letter from the government that they were being accused of having manipulated electricity markets, a serious fraud violation. After a three-year investigation, federal energy regulators had concluded that two of their investment partnerships, known as Powhatan and Huntrise, had “profited, intentionally so” from sham power trades. The Gates’s reply to the 28-page document, in its entirety:

“Your preliminary findings make no sense. Should you choose to proceed with a public notice against Powhatan and/or Huntrise, please be advised they will respond publicly and forcefully.” The Gates brothers debated whether the second sentence was redundant. By then, they had decided they wouldn’t be bullied any longer.

The brothers went public with an earth-scorching campaign against their treatment by the Federal Energy Regulatory Commission, or FERC. They’ve released hundreds of pages of internal documents that aren’t normally disclosed during an ongoing investigation, and FERC is not pleased. This is not supposed to happen, and never has.

Rich Gates says he was “completely dumbfounded” by FERC’s legal and financial reasoning. “We wanted to go open kimono,” Kevin Gates adds, “and just provide full transparency into the process to the public at large.”

The Gates case offers a rare glimpse into FERC’s prosecutorial method and the workings of the larger regulatory state in the Obama era. Since 2009, the commission has transformed itself from the boring regulator nobody ever heard of into a fearsome scourge of Wall Street and U.S. business. To great political acclaim, FERC’s Office of Enforcement has pursued everybody from big financial institutions like Barclays BARC.LN -1.33% and Deutsche Bank DBK.XE +0.03% down to individual traders and even Maine paper mills, making market-manipulation charges much like those lobbed at Powhatan and Huntrise.

FERC’s most notable scalp so far is a $410 million settlement last year with J.P. Morgan JPM -0.37% that happened to land amid the London Whale and mortgage securities political pile-on. The White House thinks well enough of the enforcement division’s work that the administration wants to promote its director, Norman Bay, to FERC chairman.

The problem is that no one understands what FERC’s definition of “market manipulation” is, only that, like Justice Potter Stewart, Mr. Bay knows it when he sees it. Though the financial stakes for the Gateses aren’t high in the scheme of things—$4.7 million in allegedly ill-gotten profits, by FERC’s reckoning—the brothers think that their reputations are worth defending. Alone among FERC’s targets, they’re doing what they promised, publicly and forcefully.

“This particular adventure began in 2008 when we cold-called Alan Chen, ” Kevin Gates says. Dr. Chen was a Houston energy trader with a Ph.D. in power engineering, and his strategy appealed to the Gates brothers. They and their friends and family set up a fund, Huntrise, which would reflect Dr. Chen’s plays.

The fund was a side investment for their personal portfolios. Their day jobs are managing a midsize advisory firm called TFS Capital. Rich Gates is among the heroes of Michael Lewis’s “Flash Boys,” and the Securities and Exchange Commission considers him a Dodd-Frank whistleblower for his role in exposing some high-frequency trading practices.

The trades on FERC trial are less exotic. Megawatts can be bought and sold like any other stock or commodity in about half the country where competitive wholesale power has replaced the old state utility monopolies. Dr. Chen was trading in a large regional market called PJM Interconnection, a transmission grid organization that covers all or most of 13 mid-Atlantic states out to Ohio.

He was placing bets on the spread between the day-ahead and real-time price of electricity, focused on rare but very profitable events that could not be known in advance. Think of a batter swinging for a home run on every pitch even if he strikes out most of the time.

Then one day in November 2009, Dr. Chen received a surprise reimbursement from PJM, retroactively paying him an honorarium for some of his past trades. He was the beneficiary of a running debate within FERC over “fairness” and who should pay for the fixed costs of electric transmission.

FERC favors the bafflingly complex over the straightforward and efficient, but to oversimplify, all buyers and sellers pay various tariff charges to participate in PJM. The process is designed to collect more of these up-front fees than transmission costs in practice. “Basically there’s a big pot of money left over that PJM has to allocate,” Kevin Gates explains.

This redistribution largely had gone to grid operators that physically flowed power through the transmission lines. But then FERC decided that since traders like Dr. Chen were also required to prepay the tariff charges, they deserved to be cut in on the rebates too. He realized—it takes a doctorate in the sciences to understand the formula’s technicalities—that at certain predictable geographical hubs in PJM and at certain predictable times, the rebates would be significant and higher than the tariff charges. As it turned out, the system would sometimes pay him to make trades.

“We liked the investment to begin with, that’s why we had money with Alan,” Kevin Gates says. “Now we have this tailwind. We were collecting rebates in addition to the normal exposure we were getting. Therefore the natural, logical response is, let’s increase our exposure.”

Another way of putting it is that since the cost of swinging was lower, the Gates brothers could try for more home runs. Around this time they founded Powhatan and ramped up their trading volume over six months in 2010. Of the Gates brothers’ initial $2 million investment, Dr. Chen lost over $400,000 in the first two days, though he went on to grow the investment to $7 million in a matter of weeks.

That drew the ire of FERC’s enforcement division, which began demanding information and taking depositions in fall 2010. At first, the Gates brothers tried to adhere to the insider playbook and hired an attorney from White & Case, a D.C.-based law firm that does frequent business in front of FERC. The insular Washington energy bar trafficks in political connections, but those aren’t so useful for clients who maintain their innocence.

Things started to turn for Kevin Gates, he recalls, during his second full-day deposition with the lead FERC enforcement lawyers on the Powhatan matter, Steven Tabackman and Thomas Olson. “I would suggest that it was intimidation tactics, aggressive behavior, which I guess is natural for a federal prosecutor, maybe what you would expect,” he says. “But there were also a lot of questions asked and behavior that suggested to me that we were seeing the world very differently and—I would suggest—they didn’t know what they were talking about.”

Mr. Gates was asked to leave the room and sat in the hallway while his lawyer conferred with the feds. The lawyer emerged to relate what the FERC enforcement team had proposed: “Kevin’s a businessman, isn’t he? He knows that it’s cheaper to settle than it is to fight this investigation.” Right then, Mr. Gates says, “I realized that we had a big problem on our hands. This was unlike anything we’d ever seen before at a regulatory agency.”

The Gates brothers fired the white-shoe practice and brought on Bill McSwain of Drinker Biddle, a Philadelphia-area lawyer who “didn’t interface much with FERC. He also used to be a Marine sniper, so he had a different approach to the world.” Mr. McSwain introduced himself to FERC by calling their conduct contrary to “established law, as well as common sense,” and that was one of his subtler letters.

Ultimately FERC claimed that Powhatan was making trades merely to harvest the PJM rebates, not transactions that had a legitimate economic purpose or generated real value. FERC calls them “wash trades.”

Yet FERC doesn’t seem to understand the difference between a wash trade and a washing machine. By definition wash trades make no money and entail no risk—a trader makes near-simultaneous purchases and sales of the same security. They can be self-dealing or used to trick another investor or inject bad information into the market. As Rich Gates put it, “Alan Chen’s trades were very different. They were spread trades that were designed to make money by themselves, they didn’t benefit some other entity, they weren’t designed to deceive. They were designed with the sole purpose of making money.”

More to the point, the Gates brothers make a compelling argument about due process. FERC debated the transmission rebates, vetted the consequences, and then wrote rules that opened the PJM rebates to traders. The commission itself had expressly predicted in a 2008 ruling that if arbitrageurs “can profit from the volume of their trades,” they “may make trades that would not be profitable based solely on price differentials alone.”

In other words, even if the Gates brothers were trying to amass rebates and nothing else, that was not illegal or illegitimate at the time, and FERC never gave fair notice suggesting otherwise. Instead, years later, the commission decided that it didn’t like the outcomes that it anticipated from the incentives it created, and decided to selectively punish some investors ex post facto. If in hindsight FERC thinks the results of obeying its rules are undesirable, then the commission should either make better rules or else give investors like the Gates brothers a public-service medal for exposing its own mistakes.

FERC did end up changing the rules, again. The rebates for traders stopped. But the assault on Dr. Chen and the Gates brothers has continued. FERC even views their efforts to exonerate themselves as compounding the original offense, such as it is.

The Gates brothers hired as consultants an all-star roster of experts in power and securities law to independently examine the facts of the case. They include Harvard’s Bill Hogan and Richard Tabors, formerly of MIT, who were the architects of the electric-deregulation movement. Another is Craig Pirrong of the University of Houston, probably the world’s leading authority on commodity-market manipulation. With their own credibility to maintain, not one supported FERC.

One of the experts, Susan Court, FERC’s former enforcement director, had “a very short meeting” with her successor, Mr. Bay, as a gesture of good faith. She informed him of what the Gates brothers were up to. Ms. Court reported that Mr. Bay “was very upset and taken aback.” Perhaps he let that cloud his judgment, Kevin Gates says.

The brothers concluded, Mr. Gates continues, that “we can’t communicate effectively with the FERC,” so they’d try to persuade “our neighbors, our investors, our business partners.” They’ve uploaded all of their case files and correspondence to a public website, Mr. Gates says that, “It’s never good as a money manager or even just a citizen to have your name in the paper as a market manipulator, but we know we’re not going to settle.”

FERC still hasn’t brought public charges or formally closed the investigation. The Gates brothers have filed Freedom of Information Act requests for records relevant to their case so that they can disclose more, and they’re more or less daring FERC to sue. The brothers seem like they’d be delighted to vindicate themselves in a court of law.

Still, their treatment does raise troubling questions about Mr. Bay’s fitness and competence to lead the larger Federal Energy Regulatory Commission. Congress gave FERC market-manipulation oversight powers with teeth—including penalties of $1 million per day per violation—only in 2005, but those powers did not receive a real work-out until Mr. Bay joined FERC in 2009. He was formerly U.S. attorney for New Mexico.

Mr. Bay expanded the Office of Enforcement to some 200 staffers from 20 a decade ago, bringing in the likes of Mr. Tabackman, who was most recently a partner at Butzel Long Tighe Patton, where from 2002 to 2005 he was a consultant to the legal-defense team of 9/11 conspirator Zacarias Moussaoui.

These former criminal prosecutors and litigators have specialized in retroactive punishments for conduct that was legal at the time. Most of these cases never go to court and end with settlements against politically disfavored defendants like J.P. Morgan (that one, like Powhatan, was led by Mr. Olson). Most companies roll over because their future business interests depend on preserving good regulatory graces and favorable FERC rulings. The Gates brothers are unusual in that their livelihoods are elsewhere, but the illogic, intimidation tactics and erosion of due process in their investigation are typical.

The larger point is that the Gates case shows Mr. Bay and FERC are really undermining the electricity markets in the name of defending them. Ad hoc settlements win political plaudits, but because companies usually neither admit nor deny wrongdoing, the settlements set no meaningful or coherent legal precedents. Aside from mind readers and fortune tellers, no one can know what the rules—or, rather, what FERC’s subjective backward-looking interpretation of market manipulation—will be, depriving the markets of liquidity and price discovery. “Shooting random people for following the law,” says Rich Gates, “that sets the markets and the world back.”

Mr. Rago is a member of the Journal editorial board.

The Weekend Interview: The Investors at War With Political Power –


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