Electricity Trader Fights Back Against Ferc Investigation

TFS founders deny charges that they manipulated the electricity market. Was Ferc overly aggressive?

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High voltage electricity power lines hang from pylons to supply the city grid operated by the Fortum Oyj energy company in Stockholm, Sweden, on Monday, March 18, 2014. Fortum’s sale of its Swedish electricity grid is drawing interest from bidders including billionaire Li Ka-Shing’s Cheung Kong Infrastructure Holdings Ltd. and Canadian pension investor Borealis Infrastructure Management Inc., people familiar with the process said. Photographer: Casper Hedberg/Bloomberg

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Powhatan Energy Fund, a power-trading partnership run by the founders of West Chester, Pennsylvania–based TFS Capital, a registered investment advisory firm that manages equity hedge funds and mutual funds, has publicly challenged a nonpublic Federal Energy Regulatory Commission (Ferc) charge that it earned $4.7 million in rebates in 2010 by manipulating a regional electricity market.

Kevin and Richard Gates, the founders of TFS, are fighting back against what they see as overly aggressive enforcement, compared with that pursued by securities regulators, on the part of Ferc, a U.S. Department of Energy agency charged with oversight of, among other things, interstate electricity sales. The Energy Policy Act of 2005 gave Ferc broadened authority to impose monetary penalties on activities involving manipulation of natural gas and electricity markets. During fiscal year 2013, the agency levied $304 million in penalties and opened 24 cases. In contrast, the Securities and Exchange Commission’s much larger enforcement unit brought 686 new cases and levied $1.17 billion in penalties the same year. Among Ferc’s high-profile targets last year were JPMorgan Chase & Co. and Barclays.

One source with knowledge of the electricity markets says Ferc has heard many complaints from virtual traders about its tough enforcement policy but has shown little sympathy. According to this source, many at the agency dismiss complaints that Ferc is “criminalizing trading” as a deliberate distortion.

Originally known as the Pennsylvania–New Jersey Interconnection, with Maryland joining in 1956, the PJM supplies power to all or parts of 10 states and the District of Columbia, in addition to the original three. A group of trading firms, including Princeton, New Jersey–based Black Oak Energy, which has not been publicly named in any investigation, appealed Ferc’s demand to recoup PJM rebates. In August 2013 the D.C. Circuit Court, hearing the Black Oak case, slowed efforts by Ferc to claw back the money, asking for reconsideration and further explanation of the action.

In August 2010 the Gates brothers received notice of Ferc’s investigation into transactions made by Houlian (Alan) Chen, who was hired by the brothers in 2008 to trade on a pilot fund and eventually on behalf of Powhatan; he also traded for his own funds, HEEP and CU. Ferc charged that Chen engaged in what were effectively “wash,” or “sham,” trades.

In the complaint, Ferc alleged the trades were designed purely to capture rebates on the regional grid, which affected electricity prices, making them tantamount to market manipulation. The Ferc Office of Enforcement’s press representatives declined to comment, and a call and e-mail to the Ferc attorney on the case were not returned.


In the preliminary complaint, Ferc alleged that Chen and his partners knew the trades were manipulative. “Chen, Gates and the Powhatan investors were aware that the large trading volumes necessary to effectuate their (rebate-based) trading strategies adversely affected the whole PJM market,” writes Ferc in its complaint.

Although admitting Chen exploited the rebate program on their behalf, the TFS founders deny that the trades affected electricity prices and insist they were market-neutral “spread” trades rather than phony wash trades. The brothers, who are twins, compare themselves to customers who clean a restaurant out of burgers offered at pennies apiece — guilty of greed, not fraud. “If there’s an ad in the paper saying burgers are four pennies a burger, even if you [speculate], ‘Oh, gosh, wonder if they’ll take those burgers back,’ it doesn’t mean you’re manipulating the market,” says Richard Gates in an interview.

The Gates brothers and their partners then went public with what had been a nonpublic investigation when they put up a web site in early March. That site, ferclitigation.com, includes Ferc’s complaint and statements from several market economists and former regulators, including former chief economists of the SEC and the Commodities Futures Trading Commission, who were compensated by Powhatan and HEEP to speak in their defense. The paid consultants include Susan Court, an attorney who runs her own energy consulting firm in Arlington, Virginia, and was the first director of Ferc’s Office of Enforcement after the regulator’s reconstitution in 2005.

“Simply put, I do not think the government should punish people for following rules the government itself makes,” said Court in her statement on ferclitigation.com.

Court said she has never before publicly opposed a Ferc position. She said in her statement she felt strongly that the Powhatan case was an issue of market design, rather than market manipulation.

The Gates brothers helped start TFS in 1997. The firm now has roughly $1.42 billion in assets under management, according to Richard Gates. TFS Market Neutral, the firm’s flagship mutual fund, employs a straightforward long-short strategy, but the firm has experimented in other markets, often testing the waters with its own money first.

While looking into high frequency equity trading strategies in 2009 and 2010, Richard Gates discovered what he deemed to be market flaws that allowed high-speed firms to manipulate prices and otherwise gain advantage. He strongly advocated for the reform of electronic markets and contributed to the SEC’s investigation of high-speed trading.

Around the same time, the brothers decided to attempt trading in electricity markets. In 2008 they tapped Chen, a former Enron energy trader with a Ph.D. in electrical engineering, to run a pilot trading program on the electricity market. They found Chen by cold calling people on a directory of power traders, Richard Gates says.

The Gates brothers backed Chen’s one-man operation, eventually forming Powhatan with investments from eight family members, friends and colleagues in May 2010. That year Powhatan invested roughly $2 million with Chen, and saw it turn into about $7 million in less than six months. Prior to Powhatan, the Gates brothers and partners had invested roughly $900,000 with Chen via their Huntrise Energy Fund, which is listed in the Ferc complaint with Powhatan, HEEP and CU.

Chen originally pitched his strategy to the Gates brothers as low risk and low return. That sounded like a good alternative to the falling stock market and low-yield bond market of the financial crisis. Huntrise was to be the laboratory to test the strategy before potentially opening it to clients.

In a niche known as the up-to-congestion market, Chen would bet on the spread between the price of electricity between two given points in the day-ahead market and the price of electricity between the same two points in the real-time market. As part of the trade, Chen had to pay to reserve a transmission line for use. For more than a year, the strategy lived up to Chen’s promise of unspectacular returns.

Then, in late 2009, Chen received notice from PJM that he was eligible for rebates on what he paid to reserve transmission lines, according to the Gates brothers. Known as a “transmission loss credit,” the rebate was designed to partially reimburse electricity providers for transmission costs. Nonprofit grid operators like PJM collect money from parties on the grid to cover fixed costs. They often redistribute any surplus in the form of rebates, like the transmission loss credit.

According to the Ferc complaint, Chen found an unexpected item on the credit column of his November trading statement: back payment of the transmission loss credit worth more than $400,000. This was a windfall in a month when Chen’s strategy lost $30,000. Chen called PJM to confirm that he was eligible, according to the Ferc complaint, and informed the Gates brothers and their partners of the windfall. Later, Kevin Gates wrote in an email about how a third party might approach the program and how they could “drive a truck thru that loophole,” as quoted in Ferc’s preliminary complaint.

Chen soon amended his trading strategy with the goal of maximizing the rebates and minimizing exposure to price changes. “Chen had little or no expectation of profit from market fundamentals but instead sought to derive profit solely from loss credits,” as Ferc stated in the preliminary findings.

The new partnership, Powhatan, was the Gateses’ vehicle to ramp up investment in Chen’s new strategy. Instead of earning or losing tens of thousands of dollars a month, Chen’s strategy was churning out an average of at least $1 million per month by way of the rebates.

PJM realized its rebate program was being exploited by virtual traders and, with Ferc’s help, kicked them out of the program and asked for its money back.

The Powhatan case took a strange turn when the TFS principals’ attorney sent Ferc a letter with a link and password for the web site it was preparing, along with a request that the agency end its investigation. Ferc published the letter on its web site, something the agency later said was inadvertent.

Ferc’s Office of Enforcement gained notoriety in the wake of the Enron case, when traders in California deliberately drove up the price of electricity, creating a crisis. As they await formal charges that would include the assessment of penalties, the Gates brothers say they and other virtual traders are being tarred with the same brush.